19 MAY, 2022
By Axel Botte
The narrative in financial markets is changing rapidly and their nervousness is a reflection of inflation fears, the expected slowdown in growth, and monetary authorities’ assessment of these risks. According to EPFR data, there have been simultaneous outflows in equity, bond, money market, and gold funds. This is certainly the sign of a disoriented market. At the same time, positioning is causing bouts of volatility in both bonds and equities, while credit and high yield spreads remain under pressure.
Conversely, selling pressure on sovereign debt, particularly Italian, is fading. The flexibility proposed by Christine Lagarde has contributed to reducing this pressure. Euro swap spreads finally seem to be stabilizing. At around 80 basis points over 10 years, this measure of systemic risk stands at an extreme level similar to the peaks of the 2008 and 2011 banking crises. All in all, sentiment shifts are currently the main driver of equity markets, despite a strong quarterly earnings season. The risk of recession and the downward dynamic of stock prices are reflected in outflows from equity funds and sector rotations unfavorable to technology and banking. Finally, margin calls now force the liquidation of positions in an increasing number of commodity markets.
As regards the monetary policy front, the Federal Reserve hammers home its message. The upcoming 50 bp hikes are now firmly anchored in market expectations. Powell has reiterated that 75 bps hikes are not being considered at this time. However, the release of the US CPI at 8.3% in April shows that the slowdown in prices was less rapid than expected. The impact of the rising dollar on import prices is limited to a few categories, including clothing. Inflation accelerates in services to 5.4%, which, given the inertia of services prices, invalidates the hypothesis of a rapid return to the 2% target… and casts doubt on the possibility that the Fed may eventually adopt a less hawkish stance. Meanwhile, in the eurozone, central bankers follow one another to announce a rate hike in July, immediately after the end of net asset purchases. The weakness of the euro has prompted some comments from central bankers. The end of negative interest rates is now also a consensus within the Governing Council. Cyclical dynamics are more uncertain; as economic surveys appear inconsistent with the stagnation of industrial production in the monetary union.
In Asia, Chinese growth also raises questions. The hardening of Xi Jinping’s domestic policy motivated by an objective of “common prosperity”, the financial difficulties of real estate developers and the zero-covid policy resulting in the confinement of 465 million people have all taken a significant tool on activity growth. Capital outflows cause a fall in the yuan, which the PBoC does not intend to oppose. The 7% decline since February erases the prior appreciation of the yuan in effective terms since 4Q21. If capital flight accelerates, the PBoC may limit CNY forward sales by Chinese banks.
In conclusion, caution prevails in all markets. Surveys of US retail investors show unprecedented pessimism about the US stock market. Implied volatility remains around 30%, while realized intraday volatility can reach 4-5% for the major stock indices.