Posted 4 July 2022
Overview: Energy price shock turns into central bank focal point
As we start the second half of 2022, the pressure is clearly building. The excess monetary liquidity – the unavoidable consequence of central banks’ pandemic-fighting measures – is now draining from markets and hitting the global real economy. Markets already sense that growth is slowing, and it is being reflected in government bond yields. The ten-year US Treasury yield has moved back down to 2.90%, having traded briefly at 3.50% about two weeks ago. The move was matched by the fall in the German ten-year Bund from 1.90% to below 1.30%, and the UK ten-year Gilt from 2.73% to 2.13%. Although 0.6% may not sound a big number, in the context of last Friday’s bond markets, it constitutes a substantial move. And, as we noted last week, markets have shifted inflation expectations lower by about 0.3-0.4% – rising energy costs would usually be associated with rises in inflation expectations. However, we are now observing a big shift – energy cost rises are having the same impact on markets as rising taxes. Russia’s grip on the price of energy appears significant and while those effects can be mitigated in the long-term, they are difficult to avoid in the near or even medium-term. This places considerable pressure on businesses and their profit margins. It also means that sales revenues are likely to suffer as consumers fret over their household budgets as the extra expenses diminish their savings. US businesses and households are also under price pressures, as demonstrated by the latest personal consumption expenditure data. US consumers increased dollar spending in May versus April by just 0.2% and inflation adjusted (real) expenditure dropped by about 0.4%.
Markets are already sensing that inflation-boosting growth is in the process of slowing quickly enough now to warrant a softening in central bank guidance towards the autumn. Nevertheless, the rhetoric coming from last week’s big central bank get-together in Portugal remained resolutely hawkish. We expect the European Central Bank (ECB) will still want to raise rates this month – there were several speakers at the Portugal meeting suggesting a 0.5% repo rate rise – and they may keep going from there. Interestingly, however, these rate increases will happen while the ECB continues to purchase assets. What it takes with one hand, it gives with the other, and that rather incongruous policy is helping to hold back rising credit spreads in the weaker nations.
Still, the negative effects of the energy war being waged on Europe may be softened somewhat for the weakest nations by such monetary policy moves. However, while European governments may want to turn on the fiscal taps to help households and businesses, the policy effectively channels money into Russia’s war-chest, unless there is also an increase in energy supply from elsewhere. This places the onus on fast expansion of tanker capacity to the US and others, and on building better political relationships the Middle East and North Africa. Across the globe, there are major initiatives to secure new partnerships, coalitions, alliances, call them what you will. Maybe, for the UK and the EU, it will also provide an incentive to bury the hatchet and return to a more pragmatic relationship model.
Challenges usually drive change, and greater risk tends to mean greater potential returns. As we enter the second half of 2022, market participants are certainly downbeat, reflected in lower price-to-earnings multiples and higher credit spreads. A resolution of the conflict with Russia is very unlikely anytime soon, but securing other energy supplies is possible. If and when that happens, the headwinds blowing against the global economy should slacken considerably.
Credit crunch begins to bite
Stocks and sovereign bonds regularly make the headlines, the travails of corporate credit markets often have a much more direct impact on companies and, by extension, the economy. Things are not looking good in that regard – with the cost of financing increasing dramatically for many businesses. The hard times in corporate credit are exemplified by investment flows. Despite sinking stock markets this year, the amount of money invested in equities has increased, albeit very slightly. Credit markets, though, have haemorrhaged capital. According to Bank of America, $200 billion has flowed out of corporate bonds in 2022. The squeeze looks widespread, affecting most sectors. Moreover, the longer-term impact of the pandemic is also being felt broadly across sectors because of extra debt taken on during lockdowns. Given the interplay between debt, default and growth, credit stress is often a clear sign of looming recession.
This makes sense given the relative risks in each region. US consumers are being hit by inflation and companies are facing higher debt payments, but neither of these are yet at breaking point. In Europe, energy prices are much higher, and show little sign of coming down. Natural gas prices are nearly six times higher in Europe than they are across the Atlantic. And the squeeze is widespread across the continent, putting serious pressure on growth prospects.
Here and across the channel, the sirens of negative economic growth that define recessions are growing louder (indeed, we may already be at the beginning of one). Strangely enough, that may mean credit stress is approaching its peak, after which bonds should be due a better performance as spreads reduce again when actual default levels become fact-based rather than fear-based. That is the view of some distressed debt investors, who suspect this could be a good low point to buy in. A contrarian view perhaps, but, with any luck, enough investors will believe it enough to turn the market around.
Investors learn to shrug off China’s Covid fears
China’s zero-Covid policy, an extreme outlier among nations’ late-stage pandemic strategies, is not changing anytime soon. This is despite its damaging effects on the economy and its unpopularity with the growing Chinese middle class. In a speech delivered at Wuhan last Tuesday, China’s President Xi declared he would rather “temporarily sacrifice a little economic growth” than “harm people’s health”. Given how long his ‘Zero-Covid’ policy has been in place, one might wonder how temporary that sacrifice will be.
It is curious, then, that Chinese equities are faring so well. The CSI 300 index has been on an upward trajectory for the last two months, and June looks set to deliver the best monthly returns in two years. Xi’s speech coincided with a slight pullback midweek, but even that had recovered by the end of Thursday’s trading. If Chinese citizens are concerned with the zero-Covid policies, investors seem unphased. Some have suggested this may be down to a softer Covid policy than meets the eye. Despite the President reiterating the party line, China’s State Council announced last week that the quarantine for international arrivals would be cut in half – down to seven days in a government facility, followed by three days at home. This comes a few weeks after the President himself declared that Covid containment must be balanced against economic growth – a sign of shifting priorities in Beijing.
We suspect other reasons for China’s stock market strength, and that investor optimism is down to policy changes in other areas, and early signs of returning domestic growth. Beijing recently signalled it would also take a less severe approach to the tech sector, which suffered from crackdowns over the last two years. This is a positive turn, and indicates a general easing up of the Party’s interventionism. Last week, the People’s Bank of China (PBoC) pledged to keep monetary policy accommodative as the economy recovers from its slowdown. It follows on the heels of earlier measures to loosen policy, such as the PBoC’s reserve ratio cuts, which have been an important factor in boosting China’s credit impulse (the contribution of credit to GDP). More generally, economic readings are improving. Recent surveys of business sentiment show a rebound from lockdown malaise, with the manufacturing purchasing manager’s index (PMI) jumping to 50.2 in June, from 49.6 in May (a level of 50 or above indicates expansion). This move is broad-based too, with all major sub-components increasing. The non-manufacturing PMI (comprising services and construction) jumped to an even greater 54.7, up from 47.8 last month.
These signs all point to an improvement in the world’s second-largest economy. And with a supportive policy backdrop (for investment at least) we should expect the rebound to go further. We should not underestimate the headwinds that zero-Covid brings, but with virus cases decreasing through the summer months, short-term growth is likely to improve.