Even if our big data based business cycle model Wave is sending early signals of a hesitant relief for developed markets thanks to smoother supply chains, it is too early to hope for the onset of a recovery already. For a recovery to be sustainable, central banks may have to switch out of tightening into easing mode which is unlikely to happen as long as inflation rages on. In the meantime, equities might still be a better bet than spread products as liquidity and European fragmentation risks in debt markets loom, while currencies will become more important as alpha sources in portfolios.
Tightening mode is on
Recently, slowly easing supply chains have fueled very early signs of a recovery for DMs – albeit a shallow one. The main reasons for supply chains being less strained are threefold: seaports have been unclogging gradually and Asian container prices have been falling thanks to easing Chinese lockdowns. In addition, semiconductor supply has been picking up providing relief to the automotive as well as other sectors. While it is true that easing supply chains could alleviate inflationary pressures over time making it less necessary for central banks to act, they will certainly continue to tighten the screws as long as inflation refuses to show any signs of retreat. Therefore, there is no doubt that the European Central Bank (ECB) and the U.S. Federal Reserve will stick to their intention to increase policy rates by 25 and 50 basis points (bps) respectively this month. In response, investors have started pricing in the worst-case scenario of a recession. This is because central banks are tightening amid patchy economic data which has given rise to the assumption that central banks could overshoot their targets and kill off growth in a futile attempt to rein in inflation. Recession fears are most pronounced in Europe right now which has pushed the euro towards parity with the US dollar in recent days.
ECB: fragmentation risk vs inflation
The recent Italian government bond auction which resulted in the country having to settle for higher yields (of 3.47 on its 10-year bonds)1 is a testimony to the fact that the ECB won’t be able to just focus on fighting inflation but that it must take the vulnerabilities of the European periphery into account. While an interest rate increase might be digestible for the bloc, further rate rises could prove problematic for the Southern states at one point as debt sustainability becomes questionable. In fact, the full extent of these issues is likely to only become apparent next year as more government and corporate bonds will reach maturity and governments and companies will be forced to refinance themselves at higher costs since the overall yield level may rise further across all European markets under ECB policy normalization. In a contrary move to the above, the yield on the Bund fell recently, as many investors flocked to safety in response to heightened worries over future growth and inflation digging in its heels. Fragmentation risk looms large, as weak growth as well as higher rate and yield levels in the Eurozone often lead to a divergence of borrowing costs between weaker and healthier member states.
Anti-fragmentation measures such as targeted peripheral bond purchasing programs have been called upon to alleviate these concerns. However, the ECB might face strong opposition from the European Constitutional Court over such measures as the European judiciary might no longer allow any quantitative easing measures at the expense of price stability in the face of rampant inflation. Should this route be blocked, the issuance of Eurobonds could offer a way out which would move the EU closer to increased fiscal integration. In any case, aligning price stability with defragmentation will prove to be a difficult task for the ECB – all the while the war in Europe continues to exacerbate the situation – and bond markets are likely to see some distortions until clarity on the path forward emerges.
Currencies as new alpha sources
Currently, equities look more attractive than spread products in debt markets, even if the latter cohort offers interesting levels of for example about 650 bps of spread on European high yield. This warrants some caution though since liquidity risks are building up in spread markets as the ECB has been retreating as their biggest buyer and will continue to do so over the next months. This is going to hurt the high-yield bond segment the most which is already exhibiting signs of becoming illiquid in some buckets. Conversely, equities offer not only some inflation protection but also higher potential to participate in a recovery should a friendly scenario of easing inflation emerge. However, it would be premature for a risk-on positioning since rising real rates push up corporate refinancing and debt servicing costs. Currencies on the other hand have become more important as portfolio components as diverging policy paths of central banks in different regions have increased carry returns that can be earned on major currency pair trading. The euro’s recent slide against the US dollar is testimony to this development. Commodities might just have seen their short-term peak, especially in case of a recession, but, as a long-term play, they still offer benefits as diversifiers as they are supported by structural trends such as the energy transition.
Investors are facing some tough choices right now as liquidity risks impose constraints on the debt side and equities depend on the current earnings season reports as well as consumer sentiment which is currently still at depressed levels. Sentiment is likely to brighten once central banks start backing off which will only happen however once things will have gone their way for at least a few months so they can be sure inflation has been put back in its cage.