- Market volatilities remain elevated with overshoots likely
- Divergent Fed/ECB rate forecasts seem anomalous in light of banking woes
- Equity returns likely to be weak compared with high-grade bonds
Although 2022 was a remarkably bad year for bonds and equities, any hopes that 2023 might illuminate a brighter path have already been dispelled as rapidly changing narratives – from recession to boom to fears of a banking crisis – all tossed and turned stock and rates markets. The result was a remarkably turbulent first quarter.
A global systemic banking crisis is arguably not the most likely outcome but it remains a tail risk and considerable caution is still warranted. It might also be foolish to assume there will not be further uncomfortable moments ahead.
The commercial real estate market, for example, is currently under scrutiny on both sides of the Atlantic – not least because of its heavy reliance on bank lending for funding. European property indices have certainly felt the chill wind of these worries.
The troubles in the various banking sub-sectors will surely lead to tighter lending standards, making it harder and more expensive to borrow money and ultimately exacting a toll on economic growth. Unfortunately, as the Federal Reserve acknowledges, it is not easy to measure the extent to which this tightening may impact GDP growth.
The uncertainties generated by the banking sector add to an already difficult and uncertain mix. Market volatilities will remain elevated as participants seek clarity, and there will be times when too much weight is assigned to every incoming macroeconomic statistic.
The move from OPEC+ to cut production by over 1 million barrels, most probably in reaction to falls in the oil price as the banking turmoil arose, was a surprise. It is a reminder of the capacity of geopolitics to inject tension and further uncertainty into global growth outlooks, as well as to inflation forecasting.
Away from the epicentre of banking disruptions, China’s reopening continues apace. COVID lockdowns impacted the service sector far more than on the industrial/manufacturing side, suggesting that the recovery may be more service-oriented. And in that respect, healthy Chinese macroeconomic data may not provide quite such a boost to its trading partners as it did in the past.
Bonds
The problems in the banking sector seem to have widened the divergence between forecast European Central Bank and US Federal Reserve policy actions over the course of the rest of this year, with pricing now showing several rate cuts by year-end from the Fed, but still some more tightening from the ECB.
Concerns are perhaps more focused on US banks, and in particular the potential for additional failures among the many regional banks. However, if there were to be a bigger crunch in the US banking sector, it is unlikely that the resulting turbulence would be fully contained. The wide rate-path divergence between the central banks seems somewhat anomalous in that light.
There also seems to be something of a disconnect between the rates market pricing significant cuts in the coming months, perhaps suggesting a Fed anxious to aid a beleaguered economy, coupled with a stock market that is back up near its year highs and inflation still quite high, if perhaps peaking.
History has tended to show that stocks and other riskier assets do not trade well compared to high quality bonds at this point in the cycle during an economic slowdown, when inflation remains high coupled with tightening lending standards.
Add in yield curve inversion, with its prowess in recession forecasting, and it could imply a very poor risk/reward for US equities, in particular compared to high-grade bonds.
Currencies
While other markets have ricocheted around this year, in foreign exchange most of the major dollar crosses have remained rather steadier, with an exception perhaps in the dollar-yen exchange rate. A scenario of US economic weakness or recession might ordinarily be a sell indication, but the dollar is maintaining its safe-haven status in the face of negative news.
DXY, the US dollar index, has fallen sharply since its peak last autumn, and the question now in light of market turbulence and (some extremely sharp) short-rate repricings is whether that speed of depreciation can continue – or whether the dollar might now be reaching some sort of a plateau, possibly even a peak.
Even after the significant depreciation, the dollar has not reached the realms of undervaluation, and investor exposure to the US currency is still high. Although inflation remains elevated, fewer ‘shocks’ from consumer price index data mean that markets will stabilise without the fear of a Fed facing the uncomfortable combination of stubbornly high inflation and a fragile banking sector.
The Bank of England, in not altering its future guidance and having to remain resolute in the face of high domestic inflation, has burnished its hawkish credentials even as the threat of US-centric bank instabilities argues for a more cautious outlook on Fed action with an earlier potential peak in policy rates.
Although the pound looks unlikely to appreciate versus the euro any time soon – as the ECB continues policy normalisation and tries to keep the tools used for financial stability separate from policy rates – the UK currency might find better support against the dollar or other G10 currencies.
In his first press conference, the newly appointed Bank of Japan governor, Kazuo Ueda, surprised a little with his statement that it was deemed appropriate for yield curve control to be maintained under current economic and price conditions. This confirmation of a more dovish stance prompted yen depreciation, not just versus the dollar but other G10 currencies too.
Europe’s energy shock may take longer to unwind
An economy’s terms of trade are defined as the ratio between the index of export prices and index of import prices. Any changes in terms of trade essentially lead to a change in the purchasing power of a country. There are essentially three types of trade shock – a commodity-market shock; a world demand shock; and a globalisation shock (such as the increasing importance of China or India or eastern Europe in the global economy).
Terms of trade can be an important driver of FX, although there does not appear to be enough evidence in history to be able equate terms-of-trade shocks with measurable changes in currency values.
Because energy demand tends to be relatively price inelastic, the need to purchase energy remains reasonably constant and so large movements in energy costs tend to lead to big terms-of-trade effects.
Over 2022, many of the world’s economies experienced significant and negative terms-of-trade shocks as energy prices soared. Net energy exporters, on the other hand, such as the US, Canada and Norway, enjoyed a boost to their terms of trade. According to the Office for National Statistics, the UK is currently experiencing its largest decline in the purchasing power of its GDP since the mid-1970s (see chart).
As energy prices soared in the weeks after the Russian invasion of Ukraine, there was such a large deterioration in the euro area’s energy terms of trade that a cumulative loss of 2.4 percentage points in GDP between Q3 2021 and Q3 2022 ensued the largest ever five-quarter loss since the euro’s launch, according to ECB economists.
According to a recent paper from the ECB*, the energy price shock tended to weigh heaviest on lower-income households, despite support from governments. In addition, despite the declines more recently in energy prices, indirect and second-round effects may mean that the shock will take longer to unwind as economies continue to adjust.
No comments yet