Updated: Aug 14, 2022
Insights, Perspectives & Trends
Inflation, Inflation, Inflation
Welcome to another edition of our “Global Macro/Markets Notes”. As we look across currencies, bonds, equities, and commodities, we see that all four of these markets have already been smelling slower economic growth ahead.
Inflation and interest rates were front and center last week, but financial markets typically look past the obvious and towards the next thing. So, it is our job to tune out the noise and focus on the important information to understand how events are unfolding and the impact on our investment strategies.
While the probability of a recession has been rising, in our view, we don't yet see the scope for a deep or prolonged downturn. Said that, we believe financial markets started to price in an economic slowdown, as they go through the typical bottoming process.
On google trends, the topic of inflation has been hitting recent highs worldwide (figure 1). Yes, the one-year US consumer price index increased more than expected to 9.1% in June (figure 2), but that is not the most relevant piece of information…
Keep reading our notes to find out what are we thinking about all of this. I hope you enjoy this report and please let us know if you have any questions, concerns or comments that will help in the future versions of our publications.
Warm regards, LeoC.
Insights, Perspectives & Trends
While most equity markets finished the week lower (see details on next section), on the surface it seems the US market is maybe starting to look “pass the past”.
On Wednesday July 13, the Bureau of Labor Statistics released June’s US consumer inflation data, which despite missing the street estimates, did not trigger a further equity market sell off like it did back in June, when US CPI data for May was released (figures 3 and 4, respectively). Furthermore, the yield on longer dated (10yrs and 30yrs) sovereign bond from major developed market, declined on the week (figure 5). By itself, is an indication that market participants are getting more concerned regarding upcoming economic conditions.
In response to the unexpected acceleration in inflation, markets participants immediately started to bet the Fed would follow the Bank of Canada and issue an unprecedented 1.0% rate hike on July 27th, their next FOMC meeting. The mood got better towards the end of the week, but a 0.75% hike is all but guaranteed.
The yield on 2yr UST ended the week up 1.5bps at 3.12%, which together with a drop in the 10yr UST yield, pushed the US Yield Curve further into negative territory. It is unclear right now how deep or how bad things can get. Nobody has any clue, but once thing we are certain: the Fed is behind the eight ball and to restore credibility after the transitory faux pas from last year, they should continue to press on the brakes despite being an unpopular measure among US voters, which will soon be heading to the polls for mid-term elections.
Under the hood of US Inflation
With concerns over inflation, interest rates and economic growth on top of the mind, our job is to tune out the noise and focus on the important information to understand how events are unfolding and how they impact our investment themes and strategies.
Yes, headline US consumer inflation is on fire (figure 6), but we think that things are changing. We believe that at least two out of the three main culprits of current inflationary pressure (energy and food), have already started to cool down.
YoY energy prices have risen almost 42%, with 7.5% in June alone; fuel oil jumped close to 100% in one year and food at home and away from home have increased 12% and 8%, respectively (figure 7).
However, since June 9, commodity prices, as measured by the Bloomberg Commodity Index (BCOM), have been decelerating sharply, down 17%. WTI oil is currently trading ~20% from its double top on June 8, at $97.29 Friday close; copper has been declining since April and is now 33% below its peak; lumber corrected more than 50% from March; and agricultural commodities, as measure by the Bloomberg Commodity Agricultural Index (BCOMAGTR) is down a little over 20% from its peak in May (figure 8).
Yet and with the benefit of hindsight, thinking it was transitory, the Fed took too long to react to obvious inflationary pressures, hoping that things would eventually fix by itself. As such, price pressures quickly spread beyond food and energy.
Removing the volatile food and energy items from the consumer price index, we still have a core inflation reading of 5.9% during the past 12 months; although it has been declining during the last three months, still way above the Fed’s 2% target.
Within the service component, the third culprit of inflationary pressures, we are paying close attention to shelter. Not only it represents close to one third of the service component of consumer price, but it is also very sticky since rent negotiations usually happens on a yearly basis during renewal time.
If there is a positive to be found on higher interest rates, the US housing sector has been cooling off as mortgage rates rise and house affordability declines. With that, house prices could decline or maybe increase at a slower pace, but as we’ve mentioned above, the passthrough mechanism of lower prices to be reflected on rents is very slow.
Thankfully, inflation expectations are still very much anchored. The latest data on Friday from the UMichigan Report showed the 1yr, as well as the 5-10yr inflation expectations, flat to slightly down.
In the end, we expect inflation to moderate in the coming months. Slower consumer demand, lower commodity prices, and improving conditions of the supply chain, will do wonders to fight inflation. However, other factors such as the war between Russia and Ukraine, the Chinese Zero Covid policy, and a tight labor market could easily derail our expectations. On our quarterly report, Navigating Global Capital Markets, we further elaborated our investment themes and scenarios; please use it as complement to our weekly notes.
What is the US Yield Curve telling us?
One of the functions of financial markets (if you don’t know all of them, I suggest you visit my education initiative: www.wallstreetable.com) is to help investors build expectations for the future; if the future turn out to be as expected today, or not, it is a different story. But generally, financial markets are forward looking mechanisms.
So, what the bond market is telling us?
Problems are coming; better yet and to be more technical, “there is an expectation of problems ahead” (keyword = expectation).
How big or how small?
We (and nobody else for that matter) don’t knows yet; maybe it won’t even be a problem, but if the future turns out to be how it is expected today, we will have a deceleration of economic activity and consequently a deceleration of inflationary pressures.
By just looking at the bond market action we can see that investors have a greater appetite for longer term “risk” free (10yr UST) vs. shorter term “risk” free instruments (2yr UST). As a result, the yield spread between those two instruments (aka: 10-2 Yield Curve Spread) has been on and off negative territory two times this year.
But trouble could already be priced in, but we don’t think this inversion signal should be dismissed. Short-term headwinds are mounting as the Fed tries to “land” the economy softly while reining in inflation. Said that, the yield curve has historically inverted on average 15 months before a recession begins, with a range anywhere from 6 to 23 months before.
So, what does all of this means to our investment strategies?
We are expecting more volatility, but rest assured that we are looking to position our portfolios to “where the ball is going to be; not where it has been”.
Inflation cooling is important to the bottom process because it will bring the fear down that the Fed will have to continue raising rates. Lastly, corporate earnings results for Q2 2022 will dictate the next leg of the market.
To be prepare for difficult times ahead, we have geared our strategies towards large capitalization companies with a strong balance sheet that trade like value stocks in the defense sectors of the US Economy.
It is Monday and like always, we look forward share with our clients, subscribers and prospects what do we think is happening within #globalmacromarkets. Our goal is to simply try to understand the “message”, if any, that financial markets are sending through their short-term movements and dynamics.
FX | Rates |Credit
Let’s begin stating the obvious, when growth decelerates (or at least hints deceleration), investors run to safe havens. With that said, our #bzcFXmonitor is showing the US Dollar Index (BBDXY) up another 1.0% on the week to reclaim 10% gains on the year.
Technically, I am looking at 1,266 for #USDuptrend support that began around mid-summer 2021. As of now, we believe the US economy is moving towards output and inflation deceleration by the end of the year. As such, we are still bullish the USD and the longer part of the intermediate-term UST curve, via the UUP and TLT exchange traded funds.
For currency pairs:
The EUR.USD depreciated another 1.0% and briefly broke below parity with the U.S. dollar for the first time in two decades as fears of a global recession intensified. Bank of France Governor François Villeroy de Galhau, tried to explain that the move in the currency pair was not necessarily due to the euro’s fundamentals. “When we look at what’s happened since the start of the year, it’s not so much the euro that’s weak,” he remarked, “but the dollar that’s strong, notably because it is traditionally a safe haven.” The #EURdowntrend is intact.
The GBP.USD sold off 1.5% and continues #GBPdowntrend.
The USD.JPY weakened 1.8% to JPY 138.57 against the U.S. dollar, as the BoJ’s pushed its dovish stance further, diverging from the aggressive tightening pursued by the U.S. Federal Reserve. During the week, the #JPYdowntrend got the yen to hit a fresh 24-year low.
The USD.CNY weakened 1.0% to CNY 6.75 from CNY 6.70 in the prior week: #CNYuptrendbreak.
The USD.BRL dropped 2.8% to BRL 5.4075; #BRLdowntrend is alive and kicking.
In our #bzcFImonitor, the higher-than-expected US CPI for June pushed short-term rates higher and long-term rates lower, as markets participants viewed the possibility the Fed could start fighting inflation more aggressively than expected, in the same fashion the Bank of Canada did, but it would inevitably damage longer term economic growth prospects. The UST 2yr ended the week 1.54bps higher at 3.12%, the UST 10yrs ended the week 16.5bps lower at 2.91%.
The closely watched #10_2USTspread descended 18.2bps further into negative territory to end the week at -0.21%, the second trip on negative territory in 2022 and matching levels last saw during the pre-Financial Crisis of 2008.
In Europe, core eurozone bond yields fell as worries grew that a cutoff of Russian gas might push European economies into a recession. Markets pared expectations for policy tightening as a result, causing core bonds to rally. Italian 10-year bond yields sold off after Italy’s ruling coalition collapsed.
Bank of Japan (BoJ) Governor Haruhiko Kuroda reiterated the central bank’s commitment to its ultra-loose monetary policy, stating that it will not hesitate to take additional easing steps as necessary. The yield on the 10-year Japanese government bond fell to 0.23% from 0.24% at the end of the previous week.
The 10-year Chinese government bond yield eased to 2.808% from 2.858% a week ago. China’s overnight borrowing rate in the interbank market dropped to 1.17% last week, the lowest since January 2021.
Equities | Alternatives
In the US, stocks remained volatile, as investors absorbed inflation data and digested earning from JPM, MS, BAC, WFC. This week, 2Q 2022 reporting season will begin earnest. Technology stocks were among the best performers in the index, helped by solid gains in Apple. Energy stocks underperformed as international oil prices fell to levels not seen since before Russia’s invasion of Ukraine.
European equities were flat to lower as central banks stepped up interest rate increases, raising fears of a global recession. Over the week, the STOXX 600 Index ended 0.80% lower, the DAX Index fell 1.16%, the CAC 40 gained 0.05%, the FTSE MIB sold off 3.86% and the FTSE 100 Index declined 0.52%.
For Asia, Japanese stock market returns were positive for the week. The Nikkei 225 Index rose 1.02% and the broader TOPIX Index ended the week up 0.27%. Ceremonies to honor Shinzo Abe, its former and longer-standing prime minister, took place across the country. The ruling Liberal Democratic Party (LDP) increased its seat count in the election, winning a majority with its coaling partner Komeito.
Finally our #bzcCMDmonitor, continued to correct. The broad-based BCOM Index lost 2.1% on the week, as industrial metals (BCOMINTR) and agriculture (BCOMAGTR) declined 6.9% and 5.5%, respectively. WTI collapsed 6.9% to end the week at $97.59/barrel. Copper suffered a 8.4% loss and Nickel plummeted over 10%.