MAY CPI PRINT AND HAWKISH ECB CRATER MARKETS
SUMMARY OF MARKETS
Any news the first part of this week that might have seemed to matter to financial markets was overshadowed by the ECB’s monetary policy meeting outcome on Thursday and May’s CPI print for the US, which was released Friday before the US open. Let’s just characterise the effect of both on global markets as UGLY!
I suppose the ECB did more or less as expected although the bias in the markets suggested a slightly more hawkish tone than anticipated even though a 50bps increase in interest rates for July was taken off the table (with a 25bps increase almost assured). Concern with inflation and the ECB’s policy response have firmly focused on the effect of rate rises on peripheral Eurozone sovereign bond yields. It all sounds so déjà vu to me, probably worthy of a stand-alone article next week.
In the US, a May CPI read flat to April (8.3%/ annum) might have been a bad surprise, but 8.6%/annum? Investors chewed that up and puked it out as both bonds and stocks got absolutely hammered Friday courtesy of the new highest inflation print in the US since December 1981. In fact, stocks sold off at the end of Thursday’s session, almost as of investors saw this coming before the close. That all sounds a bit suspicious to me, “leaky” in other words, or perhaps investors are more clairvoyant than I realise. The 8.6%/annum May read certainly makes the Fed’s post-pandemic assessment of “transient inflation” look stupider by the day. The longer these high levels persist, the less likely it is that the Fed will be able to navigate a so-called “soft landing”, meaning taming inflation without sending the US economy into a recession. US sentiment also soured in May, and as Americans increasingly worry about inflation. Politically, the prospects for the Democrats holding on to their Congressional majority in the upcoming November mid-term elections are worsening by the day.
What does persistent inflation and other global news mean for various asset classes? Here’s my take (not investment advice, etc):
US equities: Bearish / down, especially rate sensitive names. Be selective and emotionally prepared for heightened volatility. On the worst days, violent downswings will leave no stock or sector spared.
European equities: ECB has even less room to manoeuvre than the Fed, so bearish. Invest in international / global European-based multi-national companies that do business outside of Europe, because it is going to get ugly economically here.
Chinese equities: This will become a crowded trade because valuations are attractive, and the government seems to have given its tech giants a “get out of jail free” card at last. I’m not a fan of unknowns, but China probably deserves a look given what’s going on in developed equity markets.
US bonds: I don’t think we’ll see the 10y yield go above 3.25% before the economy comes crashing down. I suspect the yield curve will remain flat and perhaps invert.
US credit (HY): For US high yield, migrate towards higher-tier ratings categories. This means avoid B / CCC names that are most likely to be negatively affected by higher interest rates. As with equities though, pick the right names / sectors (less-cyclical ones). I suspect HY bonds will eventually get caught in a downdraft.
European sovereigns (govt bonds): For European sovereigns, the periphery outlook is so unfavourable at the moment as the ECB ends its QE programme and begins to raise rates that it almost cries out for a short position in weaker peripheral sovereigns like Spain, Italy, Portugal and Greece. But be aware that the ECB will likely once again cook up some sort of protection for its weaker member states, an ongoing example of moral hazard in its highest degree. Do not get caught on the wrong end of this policy action which is probably inevitable although timing is unclear.
US Dollar: I’d like to think that the USD would drift back to its historical mean (say around 90/basket), but FX is a race to the bottom. As bearish as a case that I can make against the USD in isolation, the fact is that the Euro and Sterling have even worse prospects, and I suspect both will weaken against the USD and will in fact retest recent lows.
Japanese Yen: Fuhgeddaboudit!! The Yen is going in one direction, and that’s down as the BoJ remains dovish for what could be forever.
Gold: I don’t think we’re going anywhere on this asset in spite of high inflation. I suspect it will remain range-bound.
Real estate (US residential): Easy call, first froth will come off, followed by price declines. Higher mortgage rates have to be biting. Keep in mind that US real estate is a very regional market.
Cryptocurrencies: Who the hell knows since the dynamics driving the prices of cryptos is about as clear as mud to me on a good day. But this current “risk-off” attitude would cause me to run for cover if I were loaded up in cryptos, even though they have defied gravity at times through this year’s turmoil.
Oil/commodities: Commodities benefit from inflation generally, but higher prices will also lead to a self-correction sooner or later. I still like oil and commodities (and stocks involved in both businesses) in this environment. However, demand will – to the extent possible depending on the commodity – eventually lessen because of stubbornly high prices, and/or supply will be added as producers / miners / extractors seek to benefit from record-high prices.
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
US CPI for May: US CPI was released Friday and was 8.6% for May, coming in at well-above expectations after declining slightly in April to 8.3%. As the BLS reported, this was the highest CPI read in the US since December 1981. The BLS described the increase as “broad based”, cutting across food, energy, services and nearly all other categories monitored by the BLS. The release absolutely wrecked stocks and bonds on Friday, coming off a weak close on Thursday. This read supports the hawkish approach by the Federal Reserve, but it also illustrates vividly the challenge that the Fed has in terms of taming inflation without inflicting severe damage on the US economy. You can find the BLS CPI report for May here.
ECB leans slightly more hawkish than expected: On Thursday, the ECB released a policy statement following its Monetary Policy meeting that occurred mid-week. The ECB agreed to end QE on July 1st. Interest rates were left unchanged, but the central bank stated that a 25bps increase (to 0.25%) in the key overnight bank interest rate is almost a certainty for July. This would be the first time Eurozone bank interest rates would be increased above 0% since 2016. A very simple read of the outcome and actions steps from the recent ECB meeting is here. If you want more detail, you can find the “combined monetary policy decisions and statement” here. I think this statement from the ECB regarding the revised economic outlook for the Eurozone is also insightful, especially in that both the World Bank and OECD cut global growth forecasts this week: “Euro area real GDP is expected to grow by 2.8% on average in 2022 (of which 2.0 percentage points relates to carry-over from 2021) and by 2.1% in both 2023 and 2024. Compared with the March 2022 ECB staff projections, the outlook for growth has been revised down by 0.9 percentage points for 2022 and by 0.7 percentage points for 2023, mainly owing to the economic impacts of the war in Ukraine, while growth in 2024 has been revised up by 0.5 percentage points, reflecting a rebound in activity as headwinds fade” (here for full economic outlook).
World Bank and OECD cut world growth forecasts: Both the World Bank and OECD revised forecasts for global growth down. Similar to the ECB revised forecast, both entities attributed the revisions to the ongoing and unanticipated invasion of Ukraine by Russia. The map below illustrates the World Bank’s expected world economic growth in 2022 by country.
The World Bank revised 2022 growth down to 2.9% from an earlier forecast of 3.2% (from April). The global economy grew 5.7% in 2021, so this is a sharp deceleration in global growth. Similarly, the OECD revised its outlook for global growth to 3.0% for 2022 (down from 4.1% in January 2022 outlook), and its outlook for 2023 is for 2.8% growth. The 2.8% in 2023 compares to 3.0% from the World Bank. You can find the World Bank most recent “Global Economic Forecasts” here, and the revised OECD Economic Outlook June 2022” outlook here.
US retail / Target (TGT): For the second time in only a few weeks, US retailer Target was forced to revise its second quarter 2022 guidance down. The company attributed the revision to its outlook mostly to bloated / “incorrect” inventory mix, supply-chain issues, and higher transportation costs. You can read the company’s press release from June 7th here. This had collateral effects into other US retailers, and the themes are fairly consistent.
Treasury secretary Yellen testifies before the Committee on Finance of the US Senate on June 7: Her opening policy statement, in which Ms Yellen acknowledged (like Fed Chairman Powell) on behalf of the Biden Administration to have underestimated the persistency of inflation, is here.
Boris Johnson survives a “no confidence” vote: There is a good recap on BBC here.
I’m just not feeling good about things although I am telling myself that it is perfectly normal to get caught up emotionally in the directional sentiment of the moment. The fact is that we are “open kimono” now – inflation is raging and the medicine to address it in the US, UK and Europe will be unpleasant. The ongoing unknowns around COVID (albeit hopefully fading) and Ukraine-Russia war are added unknowns that could swing markets either direction. As I said earlier in this summary, be emotionally prepared for violent swings in both directions.
This coming week we have some UK economic data (manufacturing/production, unemployment, April GDP), and US and Chinese retail sales data. Most focus though will be on a series of central bank and monetary policy decisions – the Fed on Wednesday, the BoE on Thursday, and the BoJ on Friday. It is almost a certainty that the Fed will raise the Federal Funds rate 50bps, the BoE will raise rates by 25bps, and the Bank of Japan will do nothing.
Corporate bonds (credit)
Safe haven and other assets