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Global Macro – Emerging Markets
In a world of tightening global financial conditions and questions about the liquidity implications of the now-finalised US debt ceiling, we see a degree of macro risks for EM EMEA economies, with external funding requirements the central concern. We expect EM EMEA growth to trough this year but remain below potential in the 2024 recovery. The silver lining is that subdued growth should cap inflation, facilitating monetary policy easing where external balances allow.
US Fixed Income: At mercy of inflation flaring up?
Macro View: There is a big debate going on if all of the historical leading indicators of US recessions are failing to be reliable predictors given that we are not yet in a recession. For one, we will not get the official call until the NBER determines that all the criteria have been met. It’s possible, that if the US jobs data is being overstated (and in the future gets revised) that perhaps we are already in a recession (or close to one). Meanwhile as we wait there are already crack forming under the one last major area of US economy vibrancy, the labor market. We think those cracks will continue to spread into the second half. This leaves us at the mercy of inflation. We believe inflation will continue to slide lower, but if we are wrong and it flares up again, that is the biggest risk to our Fed and fixed income views ahead.
Fed Policy: As expected, after hiking 500bps in over a year the Fed skipped and did not raise rates at the June FOMC meeting (maintaining the Fed Funds rate (FFR) at the target range of 5-5.25%). They changed the driver of potentially more hikes from “monitor incoming data” to “assess additional information” needed in order to hike. In our view suggests that the hurdle to hike in such short-order is high because they need to see inflation coming in higher and/or labor market data staying strong to hike again so soon. We remain 50/50 on the Fed hiking in July. That said, this does not preclude them from hiking deeper into the second half of 2023 if we are wrong about the path for inflation. If inflation were to remain sticky or worse were to flare-up again and if job gains remain solid, the Fed could hike again. They have flexibility to hike given that they added to two more potential hikes as per the 2023 dots median terminal rate math. Overall our contention is that the hurdle remains high to restart hiking once they have paused. If they skip again in July and the data continues to worsen (as we expect) they are likely done with the hiking cycle. Instead we see them shifting focus to QT and tweaking the balance-sheet policy.
Rates View: Our rates path is still being influenced by what we consider two competing scenarios, where both see the Fed cutting rates eventually, where the key difference is the magnitude and what will be the catalyst to see them start to ease. If inflation continues to slide lower, the real rate levels will start to turn positive versus a Fed on hold at 5 plus percent, this sort of “immaculate disinflation” along with clearer signs of economic weakness could see the Fed cut by 25-50bps. Meanwhile if macro conditions worsen and there are more credit and/or market shocks resulting in tighter financial conditions, they could cut by around 100bps. We generally stick by our initial view that these cuts can occur by year-end. However, given that the scenarios require the catalysts described below to occur, we will be rolling forward some of our easing expectations forward at each upcoming FOMC. In other words, we still see the Fed’s next major move as easing but the catalysts for such move needs to be present. This means that the timing of the first cut could get pushed back
The US dollar on a DXY basis has weakened marginally since the release of our last Global Markets Monthly in May (by about 0.5%) despite the ongoing hawkish rhetoric from the Federal Reserve which is strongly communicating a message of “higher for longer” to the financial markets. Since early May, the 2-year UST note yield is up about 90bps and the OIS market is close to fully priced for one further 25bp rate hike by September. But yields have risen sharply in many countries with the RBA and BoC both hiking rates this month and the ECB sending its own hawkish message on the potential for the tightening cycle to extend beyond the summer break. We believe the dollar depreciation despite such a large jump in yields highlights the significance of a pause and with the US economy set to weaken from here we expect the dollar to depreciate further from here. The potential for challenging financial market conditions and the ongoing global growth uncertainties undoubtedly mean limits to dollar selling but a further 5% depreciation is achievable over the summer months and into Q4 assuming the US data in July allows the Fed to remain on hold.
KEY RISK FACTORS IN THE MONTH AHEAD
• We have turned bearish on USD/JPY and the primary risk to this view is that the current short-term yield momentum to the upside in the US continues which could push USD/JPY beyond our expectations. We do accept this is a reasonably plausible short-term risk given there is only a relatively small amount of key US data that will determine whether the Fed hike rates again on 26th July. Weaker than expected inflation data in Japan would reinforce the momentum to the upside and if there is no rhetoric from Tokyo expressing concerns over a higher USD/JPY, there is a plausible risk that we could extend back above the 145.00-level over the short-term.
• The main downside risks for EUR/USD include: i) if expectations for growth outside of the US in Europe and China continue to deteriorate in the month ahead and /or ii) the upcoming tightening of liquidity conditions after an agreement was reached to raise the US debt ceiling could place upward pressure on he USD heading into the summer.
• The upside risk for USD/CNY would be the inaction of the Chinese government, with more stimulus measures are not forthcoming soon with details. Also, the US-China relation is also key factor affecting the yuan sentiment. President Xi Jinping said the US and China had made progress on a number of issues Monday as he meets US Secretary of State Antony Blinken for talks in Beijing. That said, US President Joe Biden called President Xi a dictator a day after Beijing talks.
Credit markets have recovered well from the Silicon Valley Bank (SVB) and Credit Suisse situations, underpinning a strong resilience in the European IG space in the current higher yielding environment. Credit spreads are close to YTD tights seen in late January. Central Banks’ rate hikes are pushing risks up and idiosyncratic situations may emerge as access to funding and cost of funding may become more tricky. The uncertainties on inflation and the uncertainties on rates make the overall outlooks difficult to predict.
Overall yield levels are still much more attractive compared to early 2022 but the credit spread outlook is now more volatile as a function of this uncertainty. The recent inflation trends have been mixed at best and recession fears are still present, market risk is still hard to predict. The rates market is showing considerable swings driven by changes in risk aversion. The situation in Ukraine doesn’t show signs of appeasement and remains a cause of uncertainty, but the market has grown used to it.
As a result, after a relatively prolonged rally since April, synthetic indices are starting to widen somewhat in recent days with XO widening 15bps in the last week following a significant 70bps rally since late April to 412bps (from a tight of 383bps in early February and a March 515bps wide). Pre-invasion of Ukraine XO was in the 320 area. Main is also slightly wider at 78bps following a 15bps rally since end April. While these look still relatively elevated, implying multiple defaults, they remain an easy hedge as investors tackle volatility deriving from economic performances, market risk or geopolitical risk.