Success and excess

The success of monetary and fiscal stimulus in cushioning the pandemic blow is well known. But the resulting demand surge, pressing against constrained supply, has also produced an excess of inflation and rising interest rates – a drag on equities. The next US jobs report, inflation print and Fed projections (all throughout September) will likely be critical to gauge how close the central bank is to slowing the pace of tightening. While one data point doesn’t make a trend, last month’s drop in US inflation, which was more pronounced than expected, is consistent with our view that bond yields, despite having risen quickly, have peaked at low levels vs past cycles – possibly supporting the equity market rally. We’ve recently closed our US investment-grade bond underweight and so we’re now in line with our long-term allocation. Likely constraints to gas flows this winter reinforce our European recession call, which is why we’re underweight euro area equities. The situation in Taiwan is a risk we’re monitoring. As US President Eisenhower once said, “plans are useless, but planning is essential”.

Fed up: Our conviction on euro area/UK recession has increased as the gas crisis/energy squeeze is worsening. China faces domestic challenges and has already announced some measures, but there’s no sign of large-scale stimulus yet. The US is more resilient, but recession odds have risen somewhat further, given the global slowdown plus the impact of Fed tightening and cost pressures. Inflation is peaking in the US, but not yet in the euro area/UK as utility bills push it higher. US core inflation and wage growth are moderating slightly, while inflation expectations are rolling over. Lower commodity prices ex European gas should put downward pressure on headline consumer and producer price inflation. The Fed will likely moderate its pace of tightening as growth and inflation slow.

Dollar dominance: Better growth prospects in the US and continued Fed tightening (plus bouts of risk aversion) could keep the USD on the strong side in the short term. When the Fed does pivot and turns less hawkish/more dovish, the USD will likely weaken given its overvaluation, deficits and extreme long positioning. But recession in the euro area and the UK will probably limit the magnitude of any potential EUR and GBP rebound. European energy prices continue to face upward pressure as the EU tries to build up gas reserves and the UK ‘price cap’ kicks in. Other commodity prices remain in a downtrend as global demand slows, but China infrastructure stimulus and extreme weather conditions are upside risks for industrial metals and agricultural prices, respectively.

Here’s why this matters:

What to make of the equity market rally? Despite equity markets recovering from their June lows, we still think near-term uncertainty remains high. We keep our overall equity and bond weights in line with what we view to be the best long-term allocation. We still see opportunities in trading within rather than across asset classes. We maintain our preference for more exposure in US and emerging markets (EM) equities. To increase our weights in the equities we like, we have reduced our exposure to euro area and global equities, respectively. Our positions will be profitable if US equities outperform euro area equities, and if EM equities outperform global equities. Within fixed income, we continue to prefer EM hard currency sovereigns to low-yielding government bonds, to capture the extra yield on offer.

Emerging issues: With EM – particularly China – underperforming lately, we keep monitoring our preference for EM over global equities. Much of the year-to-date divergence is driven by China and Emerging Europe. The former has to do with the impact of zero-Covid policies and the property market woes. The latter has been dominated by Russia’s invasion of Ukraine. We opened this tactical position based on the attractive discount of EM equities relative to global equities. We still find the valuation case compelling. The catalysts we view as being key to unlocking the benefits of this position – such as EM monetary policy easing led by China (which cut interest rates once again overnight) – remain in place. We’re also mindful of the domestic risks the Chinese economy is facing.

Meanwhile, we’re watching quite a few things…

It’s the economy: The purchasing managers’ indices (Tuesday) should reveal worsening recessionary conditions in the euro area, but a less steep deterioration in the UK. The market will also look at whether these key indicators show that US manufacturing activity is continuing to expand – but more slowly – and whether the vast services sector is now rebounding after last month’s setback. The Ifo business climate (Thursday) should have worsened further, given Germany’s reliance on Russian fossil fuels, the flow of which remains constrained (the Nord Stream 1 gas pipeline is going to be shut down for three days from 31 August). Friday’s US core PCE inflation (personal consumption expenditures price index ex food and energy), the Fed’s preferred measure, is likely to show a moderation both m/m and y/y (just like the overall inflation measure), which is important for the central bank to eventually slow the pace of tightening. The Jackson Hole meeting of central bankers (Thursday to Saturday) could generate headlines on the monetary policy path. Although markets haven’t reacted to headlines on Taiwan, we continue to watch geopolitical risks.

Daniele Antonucci | Chief Economist & Macro Strategist