The USD hedge
with an edge

Winter is coming: A recession in the euro area/UK looks all but inevitable given high inflation, energy constraints, interest rate hikes and the ongoing war between Russia and Ukraine. We believe a deterioration in euro area earnings hasn’t been fully priced in yet. Meanwhile, higher interest rates in the US and the economic slowdown have already led to a repricing in US earnings. The UK fiscal U-turn – followed by Liz Truss’s resignation as UK Prime Minister – is a reminder of tough policy choices. We revised our GBP trajectory higher, partly also because we now expect the Bank of England to respond more forcefully to near-term inflationary pressures. But we still believe that our strong dollar view isn’t about return; it’s about mitigating downside risks, so we’re maintaining our exposure to this key hedge at this stage.

To pivot or not to pivot: A dovish pivot by the Fed – whereby the central bank slows the pace of interest rate hikes or even cuts at some point – is likely to be a key catalyst for us to revisit our exposure to high-quality fixed income and riskier assets, but we’re not there yet. While we think a peak in Treasury yields is in sight, US inflation is still high and declining too slowly, while core inflation (excluding energy and food) is still rising. Despite high inflation in the euro area too, the European Central Bank’s window for large rate hikes is closing soon as the recession deepens and borrowing costs rise. The escalation of the energy crisis and the recent decision by OPEC+ to cut oil production may add additional downward pressure on global growth and upward pressure on inflation via potentially higher oil prices, particularly in Europe.

Here’s why this matters:

Sticking with less exposure to euro area equities: Given this evolving environment, in early October we reduced our exposure to equities, with a focus on the euro area, in favour of cash. We’re maintaining this lower equity, neutral fixed income and higher cash exposure, along with our strong (not stronger) US dollar near-term view. We still see opportunities in trading within asset classes. We maintain our preference for more weight in US and emerging market (EM) equities. Within fixed income, we prefer EM hard currency sovereigns to EU/UK government bonds. Any news following  the Chinese Communist Party’s Congress will be critical for our EM-focused investments.

Maintaining EM exposure across equities and bonds: As global growth is slowing, we have recently reassessed our exposure to EM assets. Despite a weak economic outlook at this stage, we think too much bad news is priced into pockets of EMs. So we’re maintaining our selective exposure within equities and bonds. Interest rate hiking cycles in EMs are more mature than in developed markets, which are playing catch-up. These conditions have provided a buffer to EM assets by limiting their downside during the recent market correction. The relative rate of economic growth remains stronger across many EMs, and both equity valuations and foreign exchange rates look attractive.

Meanwhile, this week looks packed with action…

European rates on the rise: The European Central Bank is likely to raise its main refinancing rate by 75 bps to 2% (Thursday). The purchasing managers’ indices (Monday) should reveal a faster pace of contraction in the euro area/UK, while the US should have continued to grow (albeit more slowly). A poor Ifo business climate (Tuesday) is likely to confirm that Germany is under pressure, with inflation reaching 11% on the European-harmonised measure (Friday). This EU/US divergence is likely to show up in the Q3 GDP reports: they should reveal an economic expansion of 2-2.5% in the US (Thursday) and a mild contraction in Germany (Friday), which we expect to deepen this winter. China’s Q3 GDP growth, earlier this morning, rebounded more than expected, but more recent data on retail sales have softened given ongoing Covid-19 restrictions. We’ll also be on the lookout for any development on the next government in the UK, perhaps as soon as today. And it’s a super-week for corporate earnings, with the main US tech companies reporting their Q3 numbers.

Daniele Antonucci | Chief Economist & Macro Strategist