NN IP: A stagflationary summer

August 25, 2022

With investors becoming more concerned about central bank policy tightening once again and forward-looking indicators strongly suggesting that economic growth will come under more pressure, particularly in Europe, risk appetite in the financial markets fell over the past week. Bond yields rose sharply, while global equities lost around 4%.

The upcoming central bank gathering in Jackson Hole and the next ECB policy meeting on 8 September will be important in providing more clarity about Fed and ECB action in the coming months. Chinese policymakers are focusing on helping the housing market. Meanwhile, the combination of drought and further Russian retaliation against Europe is increasing the risk of more gas price increases. This is the main reason we believe that, for now, inflation in Europe will continue to rise, even though we are seeing the first signs of moderation in the US. Against this backdrop we moved further underweight in fixed income in our multi-asset model portfolio.

No dovish pivots likely while inflation remains an issue in the US and Europe

Increasing pressure on economic growth combined with persistent inflation remains a major challenge for central banks. Between mid-June and early August, financial markets priced out a full percentage point of Fed interest rate hikes. This was caused by expectations of peaking headline inflation and a misinterpretation of Fed communications. Hopes of a dovish pivot evaporated in August after several Fed speakers confirmed that its focus will remain on inflation, even if economic growth slows even further. The Fed leadership will not risk turning dovish too quickly. We expect that during his speech in Jackson Hole on Friday, Fed Chair Jerome Powell will convey the same message – that the current inflation picture does not warrant a broad easing of financial conditions.

Member of the ECB’s Executive Board Isabel Schnabel will also present on Friday. The ECB is in an even more difficult position than the Fed: inflation is still accelerating in Europe due to the worsening energy crisis, while the pressure on the European economy continues to increase. The August composite PMI for the Eurozone fell again, from 49.9 to 49.2 (see figure), strengthening concerns that a recession is imminent. Nevertheless, Ms Schnabel will probably emphasize that the ECB too will focus on inflation.

We expect that the deposit rate will be increased further at the next ECB meetings, mainly due to the risk of inflation expectations getting out of control. With inflation driven primarily by energy prices, not by economic overheating, this is a questionable strategy. But, like the Fed, the ECB wants to see inflation coming down substantially before it considers adopting a less hawkish approach.

The Chinese authorities are acting to solve the real estate crisis

In China, the authorities has reacted to the worsening housing market crisis with a new round of policy easing. Last week, the Chinese central bank cut one of its main policy rates and the government announced that the state will guarantee new bonds issued by troubled real estate developers. This week, banks cut their benchmark lending rates, which are used as a reference for mortgages. New support from state banks to finish housing projects that are not being delivered was also announced.

It’s clear that the authorities have turned away from their cautious approach to the housing market’s troubles and that their priority is now to end the crisis as quickly as possible. But as we have written in previous editions of the Houseview, a crisis of confidence is difficult to resolve. Steps such as making sure that existing real estate projects are finished, providing troubled real-estate developers with liquidity and making new mortgages more attractive by lowering interest rates should help to end the decline in transactions. But it will probably take quarters, or perhaps years, before confidence in private real estate companies is fully restored.

Meanwhile, the state will play a more prominent role in the sector by taking over unfinished projects and nationalizing part of private developers’ portfolios. This will be seen by companies in other sectors as another indication that the business climate in China will deteriorate further. It will be important to watch how corporate regulation develops once the current economic downturn is over. The regulatory clampdown of 2020 and 2021, aimed at preventing the concentration of power and access to data in key sectors such as fintech, containing financial risk-taking, and enforcing a full alignment of the corporate sector with the government’s key strategic objectives, is likely to continue in 2023.

Moved further underweight in government and corporate bonds

Our multi-asset model portfolio remains positioned for more negative growth surprises, increasing pressure on corporate earnings, persistent inflation, more monetary tightening and continuous upwards pressure on interest rates. While maintaining our moderate underweights in global equities and global real estate, we increased our underweights in government and corporate bonds from moderate to large. We had previously held large underweights in these asset classes but reduced them to moderate, mainly for seasonal reasons ahead of the low-liquidity summer period. With most investors back to work and interest rates rising again, we reinstated our large underweights.

In our view, the yields of both Treasuries and Bunds remain too low. Given the prospects of quantitative tightening, the Fed’s focus on inflation and high uncertainty about inflation, we expect the US yield curve to steepen. With the curve still inverted and expectations for the Fed Funds rate to hit 3.50% by the end of the year, we see substantial upside for US rates from their current level of around 3%. What’s more, real yields up to five years are still negative or barely positive, which does not reflect the degree of tightening of financial conditions that the Fed is looking to implement. Chair Powell has stated that he wants positive real yields across the curve.

It’s a similar picture for European rates. With bond issuance set to increase in September and Jackson Hole later this week, interest rates are likely to rise. Within the ECB there are clear concerns about growth, but inflation is not moderating and energy prices remain very high. According to our estimates, a 10-year Bund yield of 100 bps should reflect a deposit rate of 0% and no more quantitative easing. We expect the ECB to continue tightening policy, but at around 130 bps, we do not believe Bund yields fully reflect this.

Rising interest rates combined with a weaker global macroeconomic outlook are likely to put pressure on credit spreads once again. In June and July, hopes of a Fed pivot led to spreads falling sharply. We believe that the widening of both investment-grade and high-yield spreads over recent weeks will continue as the market realises that central bank tightening is not over yet. Our view that equity markets will only bottom out after the Fed turns more dovish applies to the credit markets as well.