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There’s been little respite from the bad economic news hitting European economies.

The Fed’s annual Economic Symposium at Jackson Hole has provided the principal focus of attention for investors during the past week. However, we have been inclined to think that Chair Powell will refrain from saying too much pertaining to the interest rate outlook when he speaks later today. Yields have risen materially since the end of last month, when we had flagged that the FOMC had grown uncomfortable, in the wake of an easing in financial conditions.

At this juncture, the Fed has already communicated that it is in a data-dependent mode and therefore, a decision on whether to hike rates by 75bp or 50bp at the September policy meeting will rest on incoming information on inflation and payrolls over the course of the next few weeks. Broadly speaking, we doubt that Powell can give much forward guidance at this juncture and that the path of interest rates will ultimately hinge on how quickly inflationary pressures can abate, in the months to come.

This being the case, there may be more information contained in today’s PCE (Personal Consumption Expenditures) Core inflation data release. We see a moderation in inflation data pushing this series below 4% by the end of this year and if this is the case, then it remains plausible that short-term interest rates should peak around 3.75%, in Q1 next year. Should this come to pass, then we think that the US economy may be able to achieve a soft landing, though uncertainty around this outcome is unlikely to lift very soon.

Consequently, markets can continue to trade in an unstable fashion and it has been striking to observe intra-day volatility at extreme levels, even on days when there seems to be the little catalyst to drive price action. Against this backdrop, we have continued to have positive contributions on short US duration positions as yields rise. We continue to be biased towards higher yields and our current thinking is that 10-year rates around 3.25% offer fair value.

Meanwhile, there has been little respite from the bad economic news hitting European economies. The squeeze on the gas supply continues to pressure prices higher, adding to the clamor for policymakers to do something about this cost of living squeeze. One year forward electricity prices in France hit a new high at euro 870 per MWh this week, a 20-fold increase on the average of euro 41, recorded in the period between 2020-2021.

Rising energy prices thus continue to pressure inflation projections higher. Should aggregate price rises move into double-digit territory, then a 10% decline in real incomes could become a plausible outcome. As a rule of thumb, such a decline in real incomes could well translate to a drop in GDP of around 4% based on prospects for consumption. From this perspective, the risk is that the looming recession may easily be as severe, in economic terms, as that witnessed in the wake of the GFC in 2008.

Attempts to mitigate this by utilizing the government balance sheet to cap energy prices could add around 4% to fiscal deficits, pushing these to levels between 8-10% across European economies, unless gas prices can return to 2021 levels. This will clearly depend on a cessation of hostilities in Ukraine and an end to Russian sanctions, but it remains very difficult to project this outcome anytime soon. Meanwhile, should pipeline flows cease altogether, pushing governments into rationing of power supply, later in the winter, then this could represent an additional downside risk, which could point to an even more challenging outcome.

Clearly, a major difference compared to the recession of 2008, is that monetary easing was deployed to support growth, whereas, in the current period, it is necessary to hike rates in order to fight against inflation. This means that fiscal policy is the only tool available to support aggregated demand, yet with deficits pushing toward double digits, it is questionable how much fiscal space the governing authorities will be able to utilize.

Government funding costs are set to accelerate, though, the lengthening of average maturities over the past decade will help to act as a brake to this. Debt stability metrics linked to debt-to-GDP calculations will be supported by higher nominal GDP on the back of high levels of inflation. Notwithstanding this benefit, it seems likely that countries such as Italy and France may see an overall increase in the debt ratio in 2022 and 2023.

The macro backdrop across Europe leads us to project higher yields and we have continued to add to short rates positions in the Eurozone and UK, just as we have had positive contributions on US rates shorts. We continue to express a cautious view with respect to risk assets in the region and would not be surprised to see credit spreads push back towards their wides for the year if newsflow continues to paint a gloomy picture as we expect.

The one caveat preventing this is the fact that many investors are already positioned very bearishly on European assets. Yet, with supply set to pick up at the start of September, we are cautious that new deals may need to be priced at a material premium in order to attract demand, leading to a more broad-based re-pricing in spreads as this occurs.

Of course, should we hear the news that Putin wants to withdraw troops and push for peace, then this whole outlook could turn on a dime. Yet aside from this, we think that it is right to maintain a cautious outlook on an overall basis and we continue to see better opportunities in USD assets compared to their European peers. In FX, the dollar made headlines breaking below parity versus the euro during the course of the week. Based on divergent fundamentals, we suspect that the USD trend could have further to run.

However, the large US current account deficit, plus stretched PPP valuation of the greenback, leaves us wary of adding to existing dollar longs at this point. Elsewhere, we continue to maintain a bearish outlook on the pound (along with all other UK assets) and the recent bingo game of calling for an ever-higher top in UK CPI shows no sign of stopping just yet. We also retain a negative stance on the Polish zloty and Czech koruna, looking for a macro divergence to show up more in relative FX valuations in the months ahead.
 

Looking ahead

The coming week represents the last throes of summer before September arrives and markets go ‘back to school’.  At the start of August we added short-duration positions, as yields appeared to have fallen too far, but with rates having risen since we have found ourselves progressively having positive contributions and flattening out risk.

We have also been flattening out exposure in risk assets, seeking to pare long exposures and reduce directional exposure. Consequently, as we approach the end of the month, risk levels have been reduced materially and we think that this is appropriate given a relatively uncertain short-term backdrop.

It isn’t clear to us that there is a very obvious ‘back to school trade’ at this moment in time. Rather we are inclined to continue as we have done, looking for opportunities to sell on strengths and add on weaknesses. Volatility seems unlikely to abate any time soon and this should lead to opportunities.

In this context, taking a patient view and waiting for clearer, asymmetric opportunities to present themselves, is our preferred approach. Macro divergence as we are witnessing between Europe and North America at this point is historically unusual and the remainder of 2022 looks to remain as bumpy as the rest of it has been.

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