The main driving factor for markets since the beginning of the year has been the sharp rise in key rate hike expectations in the developed economies. This has put pressure on asset classes. Initially, the main channel of impact was the rising discount rate. In recent weeks, an increasing probability of recession (falling profits) has also been added, triggered by possibly overly restrictive monetary policies.
Last week, Fed Chairman Jay Powell reiterated the Fed’s hawkish, and therefore bearish, stance. He said, “The process of bringing inflation down to 2% will also involve some pain, but the most painful thing would be if we failed to fight it and inflation became entrenched at a high level in the economy,” he said. “The question of whether or not we can achieve a soft landing may actually depend on factors we can’t control,” Powell added. “But we should control the controllable … there’s a job to be done in terms of demand.” In the wake of the last 50-bp hike, Powell had already hinted at a 50-bp increase for each of the next two FOMC meetings. By the end of the year, the benchmark rate is expected to be 2.75%.
Even the ECB is sounding increasingly hawkish. ECB President Christine Lagarde said in a speech that she expects the bank to stop expanding its balance sheet through bond purchases “early in the third quarter” and raise interest rates “some time” after that, “which could mean a period of only a few weeks.” A key rate hike in July (discount rate: +25 bp to -0.25%) is likely. A key interest rate of 0.25% is expected by the end of the year.
Negative Feedback loop
A negative feedback loop has now been established. Since the beginning of May, the sharp deterioration in the financial environment (Financial Conditions) has led to falling yields.
- Falling market expectations for future policy rates.
- Falling real yields.
- Falling priced-in inflation expectations.
Thus, the negative economic arguments (worsening profit expectations) are currently dominating the inflation fears. Despite the stagflationary environment, credit-safe government bonds are functioning, albeit only to a limited extent, as a hedge against falling equities.
Geopolitics and energy
Some lasting effects of the war in Ukraine are becoming increasingly clear. The relationship between the West and Russia has been permanently disrupted. Sweden and Finland will apply for membership in NATO. The war also has far-reaching consequences at the energy policy level.
According to the European Commission’s draft, the EU will have to spend nearly 200 billion euros over the next five years to ensure its energy independence from Russia. The Commission has already said it expects the EU to be able to cut Russian gas imports by two-thirds this year and has urged member states to replenish their gas storage facilities before next winter. It is also seeking member states’ approval for a sixth sanctions package, including a phased-in embargo on Russian oil this year. The proposals will be published within the next few days. The biggest recession risk for Europe is an immediate gas supply stop by Russia.
Slumps in China
In China, overall credit growth fell much more than expected in April (CNY 910 bn after CNY 4653 bn in March). The slowdown was broad-based (consumer and corporate sectors) and can be explained by weak credit demand due to the lockdown measures. In particular, the low issuance of government bonds is surprising (CNY 391 bn after CNY 707 bn), so this indicator does not provide evidence for additional fiscal support measures. Export data were also particularly weak. In April, exports fell by 3.4% pm, marked by export slumps to the Western world (US: -7.9% pm, EU, -8.5% pm). The lockdown measures slowed exports due to supply chain disruptions.
High inflation and poor sentiment
Inflation rates continue to be very high in the month of April. At least there has been a decline in price increases in the USA (0.3% pm / 8.3% pa after 1.2% pm / 8.5% pa). If commodity prices do not continue to rise, inflation rates may indeed be close to their peak. However, with regard to components, the still above-average price increases were broad-based, and inflation rates have risen further in numerous other countries. The key question is whether high inflation leads to permanently higher inflation expectations or whether the significantly higher price level leads to a reduction in demand, which keeps inflation expectations low. Slumping consumer sentiment argues for the latter. In the USA, consumer sentiment in May (source: University of Michigan) fell to its lowest level since 2009.
Improved outlook for second half
The following assumptions support an improvement in the financial environment for the second half of the year:
- Economic recovery in China in the second half of the year.
- Raw material prices remain stable.
- There are no abrupt supply stops for energy.
- Inflation rates tend to fall.
- Central bank policies do not become restrictive.
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Prognoses are no reliable indicator for future performance.