Global inflation (except in China) is accelerating to the fastest rate since the 1970’s. US CPI accelerated to 9,1% yoy in June, Euro zone CPI was up 7.75%, German whole sales prices rose 21.2% yoy. Oil and other commodities were the main culprit at the start of the year boosted by increasing demand from the re-opening after the pandemic.
Industrial metals, which were already underpinned by increasing demand from a greening and transitioning economy and a more limited supply due to underinvestment over the past few years, got a further boost from the Ukraine/Russia crisis. Inflationary pressures are now broad based stemming from food, services to real estate, and wages.
Inflation could moderate in the second half of the year if the recent decline of oil and commodity prices continue, but inflationary forces will not evaporate soon. 1) Western economic sanctions against Russia will have a long term impact on European economies as the EU faces the difficult task of finding alternatives to Russian oil and gas. European buyers have to look elsewhere, stretching supply from countries as far away as South Africa, Australia and Indonesia, where quality varies. This is likely to result in an ironic global scramble for coal, the dirtiest fossil fuel, endangering the path to a greener economy. 2) The transition to a greener economy and clean energy will be a long, slow and costly process, with huge investments needed as infrastructure needs to be put in place first before being able to distribute such energy.
The European Commission raised its estimates for euro zone inflation, which is now expected to peak at 7.6% before falling to 4.0% in 2023.
Source: Refinitiv, Bolero Capital
With major central bankers obviously behind the curve, hawkish stances are likely to stay
We believe central banks will continue to act aggressively in a desperate move to keep prices under control.
The Bank of Canada this week raised its main interest rate by 100 basis point to 2.5%, its biggest rate increase in 24 years and above market expectations for a 75 bps increase, so becoming the first G7 country to make such an aggressive hike in this economic cycle. The central bank said more hikes would be needed as it is expecting inflation to remain around 8% in the next few months.
The US Federal Reserve is under increasing pressure to follow suit. Following the latest CPI report, futures have now priced in a near 80% probability of a full percentage point hike at the coming meeting. Core CPI cooled down to annual rate of 5.9% but has still a long way to go before approaching the Fed’s average annual 2% inflation target. The labour market remains extremely tight, which means and it will likely take time before it will cool down to a more sustainable level, leaving room for the Fed to maintain its hawkish stance until it get evidence inflation is under control. If history can be of any guide, a 5% CPI could stir the Fed to raise interest rates to 4%, and push 10Y US treasury yields to 5%.
Source: Refinitiv, Bolero Capital
The odds are rising of a marked slowdown with a potential recession in Q422 or Q123
Evidence is piling that uncertainty about the path of economic recovery, stubbornly high inflation and rising interest rates are weighing on business and consumer confidence.
While Global PMI data still point to economic growth, the forward looking components like new orders already point to contraction. Even if inflation growth slows in the second half of the year due to favourable comparison basis, prices will remain high in absolute terms, endangering affordability of big item tickets for many households. The withdrawal of the stimuli that were deployed to counter the pandemic-induced disruption of the economy together a potential reverse “wealth effect” due to market correction will weigh on disposable income, curbing consumer spending, eventually leading to recession.
The European Commission cut its forecasts for GDP growth in the euro zone to 1.4% in 2022 and 1.5% in 2013 largely due to the impact of the war in Ukraine. As the war is now projected to last several years, risks remain tilted to the downside.
China’s zero covid policy is expected to persist well into 2023, suggesting that the world’s largest economy will continue to be a drag on world demand and growth.
The US yield curve, measuring the gap between yields on two- and 10-year Treasury notes and seen as an indicator of economic expectations, has inverted again to -23,50 basis points. Every time since 1978 that the 2/10 curve inverted, recessions eventually followed. Recessions did not closely follow the initial curve inversion. Rather, each of the six recessions since 1978 began an average of 15 months after the curve first inverted. The shortest inversion-recession period was 158 days, before the 2020 recession, while the longest was 1,010 days, ahead of the 2001 recession. The 1990, 2001 and 2007 recessions were preceded by double-dip inversions, (source: S&P Global Market Intelligence).
Fed research published this week based on modeling of bond-market yields puts the chance of a recession next year at about 35% if the Fed sticks to its expected baseline rate-hike path, but at 60% if the Fed removes accommodation faster.
Source: Refinitiv, Bolero Capital
Earnings estimates are facing downside revision risk
Corporate growth expectations for Q2 and FY22 are declining. According to Refinitiv Q2, aggregate annual S&P earnings growth has been revised down to 5.7% from 6.8% forecast at the beginning of the quarter. The quarterly season is kicking off on a sour note with JPMorgan and Morgan Stanley reporting downbeat results hit by higher provisions to cover potential losses as threats to global economic growth are increasing. The odds are rising that corporate guidance to analysts will be adjusted noticeably to the downside, leaving room for further market correction.
Investment conclusion
We think it is too soon to call for a bottom in both equities and bonds. Fed’s tightening above market expectation has the potential to further derail financial markets. We think another 10% correction from here is still possible
We keep an Underweight in equities, US being the preferred market due to the strength of the dollar.
The Fixed income portion is concentrated on short duration bonds (IG, HY, Inflation linked). EM debt remains vulnerable to rising US rates and a strong dollar.
The charts that keep me awake at night
The Stoxx 600 is showing a worrying pattern similar to the one seen during the 2008-2009 Global Financial Crisis (GFC).
Commodities, as mirrored by the CRB index is the starting the same downtrend amid prospects of slowing demand and potential recession.
Source: Refinitiv, Bolero Capital
