ECB President Christine Lagarde opened her post-Governing Council meeting press conference on June 9th with a deliberate statement: “High inflation is a major challenge for all of us. The Governing Council will make sure that inflation returns to its 2% target over the medium term.”
At the meeting, the ECB pledged to raise interest rates from its record low levels – the deposit rate is currently at -0.5% – starting in July, and then again in September, while ruling out balance sheet reduction for now – likely for fear of impairing monetary policy transmission potentially triggered by increased peripheral spreads.
The deliberation comes after years of undershooting their own inflation projections – despite negative deposit rates, large liquidity facilities and several different asset purchase programs – and as ECB officials are confronted by an exogenous shock that threatens both price stability and growth. Indeed, inflation rose mainly due to the food and energy components in the eurozone in May, a result of sanctions and of Russia’s reaction, which is targeting gas supplies to countries that have been most vocal in supporting the Ukrainian cause. The bad news for the ECB is that this pressure is unlikely to subside anytime soon, as relationships between the European Union (EU) and Russia are expected to remain fraught for the foreseeable future.
Crucially, however, the ECB acknowledged that these (mostly) supply-driven price increases have already been transferred to goods and services outside of food and energy, which pushed staff to revise inflation projections up “significantly.” According to these revised numbers, annual headline inflation will only subside in 2023 (3.5%) and is expected to revert (approximately) to the 2% target in 2024. Core, however, while substantially lower than headline in 2022, is likely to remain “sticky,” and above target, for the next two years.
While the ECB statement blames the war for its disruptive effect on trade, shortages of raw materials and elevated commodity prices, even before the war started there were signs that wage increases were to be expected, as a good percentage of German workers – for instance – managed to obtain substantial raises from renegotiating collective contracts.
Going forward, the ECB’s job is likely to become even more challenging, as monetary policy can be rather ineffective against exogenous shocks, and tightening can damage the economy without taming inflation. Regardless of short-term policy decisions, eurozone long end rates appear to have plenty of room to go, especially in the periphery and especially if projected inflation remains sustained for a longer period. The effects of ECB’s tightening pledge are already evident on Italy’s 10-year bonds, with yields now close to 4% and the spread with German Bunds at 230-250 basis points. And real monetary tightening has not even started yet.
European bonds are likely to suffer from further downward pressure, and investors are expected to be keeping a close eye on the next policy moves. Should inflation continue to bite in Europe, the ECB may decide to move 50 basis points per meeting, which will make peripheral bonds even less appealing, in our view, regardless of whether the ECB will redirect some of its Pandemic Emergency Purchase Program (PEPP) envelope reinvestment capacity towards the periphery, and irrespective of the central bank’s efforts to come up with a long-term solution for what is essentially a shortcoming in the design of the euro area.
On the equity side, following the ECB’s decision, the financial sector also sold off heavily – as many European banks are heavily exposed to sovereign bonds. This is unlikely to subside, in our view, as debt levels continue to increase in the eurozone, and growth dwindles.
Compared to that, the Federal Reserve’s task is relatively easier. As financial conditions in the US tightened further due to market repricing after a first round of interest rate hikes, the Fed appears to be comfortably ahead of the curve and can calmly reassess the situation. That is not to say it is not flexible, as its strong reaction to the above-expectation inflation number suggests. Its decision to partially front-load its hikes starting from its June meeting – with a last-minute 75 basis point rate increase – shows determination to bring inflation under control.
Importantly, however, compared to Europe, US inflation is less related to food and energy and, while also partially supply-driven, is supported by wage dynamics and strong consumer confidence, which makes it more sensitive to higher rates.
The Fed will have to walk the fine line between excessive credit tightening that can trigger a hard landing, which may potentially translate into a short recession, and maintaining the credibility of its inflation taming strategy. But dollar strength – partially driven by the US economy’s relative insulation from exogenous shocks – can help with keeping inflation in check. On the other hand, euro weakness has been alarming for the ECB.
The Fed is also reducing its balance sheet by $30 billion in Treasuries and $17.5 billion in MBSs per month and is expected to double this pace starting in September. Again, this is a luxury the ECB does not have at this point, as it needs to keep an eye on potential increase in sovereign peripheral spreads.
In June, the Fed also updated long-term US economic projections (bringing the median GDP growth for 2022 down to 1.7%), and the dot plot, with Fed Funds projected to be at 3.8% by end 2023. Should fears of an uncontrolled inflation prevail – which is not the case at this point – we would see the long duration yields increase to 4-5%, but these fears, if they exist, are likely to be balanced by recession fears, which are likely to push that yield down.
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European assets are likely, in our view, to remain under sustained pressure. On the other hand, we believe US assets – especially the ones that are less correlated with growth stocks – are likely to benefit from stronger dollar, peaking inflation, and higher insulation from geopolitical events.
Throughout the pandemic, US “exceptionalism” – America’s potential to recover earlier and better than other countries – has been a dominant theme among investors, the result of expansive fiscal policy, early access to vaccines and swift reopening compared to Europe or China.
Inflation also appeared earlier in the US than in other developed countries, forcing the Fed to act quickly to tame it and pushing the dollar up – which contributed to attracting more capital. And contrary to the sentiment in Europe or China, the consumer sentiment in the US continues to be marginally positive. On the other hand, Europe is contending with geopolitical issues – a war at its doorsteps – while China remains bogged down by its own zero COVID policy, which is damaging the economy.
This is likely to mean, in our view, that the dollar will remain bid, and that while the rate curve in the US has already begun to stabilize, in the eurozone it is just about to start reflecting inflation numbers and central bank tightening projections.
While there is currently a large amount of capital looking for opportunities, and perhaps both Europe and China are looking attractive given how cheap they may have become, it is likely that US assets will remain front and center of investor preferences going forward.
But while the S & P 500 P/E ratio has gone down to 23x, it is still high compared to historical standards, mostly because growth tech stocks, which dominate trading and investor preferences, are still – in our view – overvalued.
In a highly inflationary environment, some private assets – such as real estate and art – can perform well, and can remain attractive even when inflation subsides due to their low correlation with equity markets. In addition, structured notes can help mitigate market risk by offering a floor that limits investor downside. Yieldstreet has been offering access to private market products since its inception, and plans to continue expanding its product portfolio going forward.
2 In a context of higher inflation, markets may simply decide to fight the ECB, not to mention potential legal problems related to issuance and issuer limits.
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