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Euro Area Macro
- The narrative of a resilient euro area economy is being challenged after a series of gloomy business surveys and a downward revision to the Q2 GDP estimate. Risks of a recession in H2 have clearly risen.
- The German economy looks particularly vulnerable as the industrial sector continues to struggle in the face of weaker external demand and structurally higher energy costs. It’s hard to see much scope for a meaningful bounce.
- We look for GDP growth of just 0.6% in 2023 and 0.9% 2024. Risks are tilted to the downside. Our chief concern relates to the lagged effects of rapid ECB tightening and the withdrawal of energy-related fiscal support on activity.
US Fixed Income: Energy-induced inflation is a growth tax, but will keep central bankers on guard
Macro View: In our last US update (back in mid-summer) we highlighted the major risk on the inflation front wasn’t core inflation but that it would be a resurgence of energy-induced inflation. Our concern was and remains that, if it’s happening during the least favourable time of the year, where the seasonals and base-effects flip in the opposite direction it could reignite inflation fears. Well, we are in that window now and unfortunately oil prices are making a push higher which will feed into the headline measures of inflation readings. We do not know how far and how high this move up in oil will go, but the longer we see higher energy, at this stage of the cycle will be more of a tax on growth but it can still rekindle fears of inflation making a come back (which will keep central banks on guard).
Meanwhile the US economic data has been once again sending mixed signals, a common feature all year long (if not since the post pandemic period that we have been in). Different nowcast models are pointing to a stronger Q3 reading of GDP. Yet the majority of the forward leading indicators are still suggesting that a recession is the next state the economy falls into (and not a “soft landing” as most are now expecting). We believe that the data will start to soften in the 4th quarter into the cold days of winter of 1Q24 as a large subset of consumers will need to start to pay their student loan monthly payments, the base-effects for fiscal support flip once again (providing less fiscal support) meanwhile the lags of the most aggressive hiking cycle from the Fed comes into full-effect.
Fed Policy: Although the FOMC did not hike at its September monetary policy meeting, they kept the door open to potentially delivering future hikes if appropriate. The major development at this FOMC meeting was their intent to hold rates at a restrictive level until inflation trends convincingly move down toward the Fed’s 2% target. In our view, given the sequence of skipping every other meeting, the risk of a November hike has increased. That said, Chair Powell reiterated that at this stage, after one of the fastest and largest hiking cycles in modern financial history, they remain data dependent and are mindful of the “long and variable lags”, which have likely been made longer given the large fiscal injections the economy has had at various times in this cycle. With a lot of things that could derail the economy between now and November FOMC, we think they skip again, and that the July FOMC hike was the last in the cycle.
Rates View: A Fed that aims to stay “higher for longer” may also be trying to a.) have the bond market normalize and do tightening for them and b.) do away with the concept of a “Fed put”. We had a 4.5% upper range level target for 10s in Q3. With that hit, the risk is for another technical breakout towards 4.75%, even 5% on 10s. If it’s a spike we don’t think it will last.
The US dollar on a DXY basis has been on a steady path of appreciation through the latter part of the summer. In fact on a DXY basis, the dollar has gained for ten consecutive weeks, a record period. In that sense, we should become a little more wary over the sustainability of the momentum to the upside. A lot of negative sentiment is now reflected in the price of currencies versus the US dollar. On an RSI-basis, the DXY index is trading close to the 70-level and exhaustion could set in quickly if there is any change in the relative macro backdrop. Our forecasts assume there is no further rate increases from the Fed but the risks are high and if the data remains resilient, a November hike is feasible which will likely see the dollar advance further. Still, the scope for a sustained move stronger we believe is limited from here. Slowing consumer spending in the US, a continued weakening of the labour market, and the ongoing transmission of monetary tightening is likely to become more evident and help prompt a reversal of dollar strength.
KEY RISK FACTORS IN THE MONTH AHEAD
- We have turned neutral on the near-term outlook for USD/JPY on the assumption that any break above the 150.00-level would be fought through FX intervention and/or a further shift in policy to a less accommodative stance. That would mean a reversal of any move higher would be prompt. A key risk therefore is that the tolerance of yen weakness by the Japanese authorities is higher than we assume and Tokyo accepts a move through 150.00 without much opposition. The primary risk the other way is that the US economy turns weaker more quickly than assumed with a bigger drop in yields resulting in a sharper correction to the downside.
- The main risk to our neutral view for EUR/USD is that downward momentum extends further in the month ahead. The USD would be encouraged to become even more overvalued if the US economy remains resilient and the Fed continues to indicate that it is planning to hike rates in November or December. At the same time, the EUR could weaken further if evidence continues to build that the euro-zone economy is contracting in the 2H of this year while the rising price of oil poses is curtailing investor optimism over a pick-up in growth as the cost of living crisis eases.
- One upside risk for USD/CNY is that the large negative interest rate differentials over the US could trigger bigger capital outflows from Chinese domestic markets. Also, fading optimism over China’s property market recovery may dent sentiment towards the yuan when downswing data were seen in the high frequency data of the property market.
Credit markets have shown steady performance in recent months with spreads close to the post CS tights, after a short lived summer widening in August. Central banks from ECB t the FED have signalled a higher for longer rates mantra, underpinned by a relatively benign economic backdrop as inflation is still stubborn. The recent decisions at OPEC are pushing the oil prices back up complicating the medium term picture for the higher beta part of the credit spectrum, as idiosyncratic situation may emerge.
Overall High Grade credit remains an attractive area for investors, given the mixture of strong underlying fundamentals of the bulk of the members of the index and overall still elevated yield levels, close to multi year highs. However, the credit spread outlook is somewhat volatile given the mixed recent inflation trends and with market risk still hard to predict. The situation in Ukraine doesn’t show signs of appeasement and remains a cause of uncertainty, albeit the market has grown used to it. China domestic economic uncertainties, mostly driven by the weakness in the real estate market there, add to the overall volatility in risk sentiment.
As a result, after a relatively prolonged rally since March until August and post the August wobble, synthetic indices are starting to widen somewhat in recent days with XO widening of 35bps since the mid September tights of 389bps to 423bps (from a March 515bps wide). Pre-invasion of Ukraine XO was in the 320 area. Main is also 10bps wider at 78bps following the post CS tights of 66bps in July. 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.