Over the week to 11 May, global equities lost 7.1% (MSCI AC World index in US dollar terms) in a market that continues to be dogged by erratic moves and a risk-off stance amid concerns over growth and expectations of sharply higher US interest rates. We believe asset allocation decisions should be reactive and fluid in such conditions as they could point to a market regime change.
Some knowns, many unknowns
It is easy to have a pessimistic view given that US policy rates could rise rapidly and push the country into recession. Meanwhile, European economies struggle with the fallout of a geopolitical crisis – all this at a time when global manufacturing continues to experience supply difficulties arising from Covid restrictions in China.
Some economists have already made this their central scenario. It is not the case for our research teams, but we are obviously conscious of the risks and headwinds.
Fed – Never more behind the curve
At his press conference on 4 May, Jerome Powell, Chair of the US Federal Reserve, promised a ‘soft landing’ while reiterating that, “Without price stability the economy doesn’t work for anybody, really”.
Looking at domestic demand-related indicators, the US economy is still working rather well. On the employment side, net job creation was strong at 428,000 in April, slightly ahead of market expectations, and taking the total for the year to nearly 2.1 million.
However, there was also a significant drop in labour force participation from 62.4% to 62.2%. There appear to be ‘outflows’ from the total workforce that are still difficult to analyse, while participation rates have remained well below their pre pandemic level of 63.4% in February 2020. Still, the jobless rate held steady at 3.6%, while wage increases seem to be starting to plateau.
On the US inflation front, the latest numbers do not point to stability: The consumer price index, excluding the more volatile food and energy components, jumped by 0.6% between March and April ahead of the 0.3% consensus forecast. Core inflation declined only modestly year-on-year from 6.5% to 6.2%. Part of the unexpected month-on-month acceleration was due to the surge in airfares, but the increase in the price of services as a whole was also strong.
Although we do see signs of inflexion in the coming months, US inflation is likely to remain high and weigh on household purchasing power.
We believe it is now clear that, contrary to initial interpretations, Powell did not intend to rule out 75bp rate rises on 4 May, but simply indicated that such an increase was not something policymakers were ‘actively considering’. The Cleveland Fed President made it even clearer: ‘If we don’t have inflation moving down [in the second half of the year], we may have to speed up [policy tightening].”
Fingers crossed then that the Fed can engineer a soft landing, or at least, that any speeding-up of its inflation-busting policy action does not do too much damage to the US economy.
The European Central Bank became more hawkish
It was only late February when observers thought the ECB would delay the normalisation of monetary policy in the face of the slowdown in Europe due to the energy price shock. Just two months later, multiple ECB statements have raised expectations of a rise in the deposit totalling 75bps between now and the end of 2022.
President Christine Lagarde, who had previously steered clear of any bidding-up of hawkish comments, said on 11 May that the Asset Purchase Programme (APP) would end in June and that the first rate rise would come just ‘a few weeks’ later. This confirmed market expectations that the ECB will raise rates at the 21 July policy meeting.
It appears the ECB assumes that the economic slowdown will not last long, so it is opting to fight inflation. An ECB council member, the governor of the Banque de France said: “The ECB will do what it takes to bring inflation back to around 2% in the next two years.”
Indeed, the latest economic data is pointing to an improvement after the eurozone economy’s soft patch in the first half of 2022, due, in particular, to the drop in private consumption during first quarter 2022 when Covid restrictions were still in place.
Germany’s ZEW indicator of economic sentiment, which worsened sharply in March after the invasion of Ukraine, stabilised in April and improved slightly in May. France’s INSEE statistics office noted, ‘Surveys reflect the growing uncertainty, but also a certain resilience in the business climate’ in France. It expects a modest rebound in French GDP in second quarter 2022 rather than a continued contraction.
We expect a tangible growth acceleration in the eurozone in the second half of 2022 as business investment plans are holding up and the labour market remains strong.
In the US and Europe, the downside risks to growth should not be ignored. For central banks, however, they do not seem to divert them from their determination to normalise monetary policies.
Against this backdrop, bond markets are likely to remain volatile. Since the beginning of May, the yield on the US 10-year T-note has moved between 2.90% and almost 3.15%, while the yield on the 10-year Bund rose close to 1.15% before closing below 1.00% on 11 May.
We remain convinced that a short-duration exposure is warranted, but will adjust our positions when we judge price moves, in either direction, to have become excessive.