“…the wrong theory for the wrong man”
Depeche Mode, Wrong
In our last piece, we discussed the recent evolution of the dominant focus of financial markets - from inflation to growth, via a rapid evolution in the monetary policy reaction function. Expanding to discuss what a recession might look like if Fed tightening induces one. During the brief hiatus in our writing, this evolution has matured - Markets are now very clearly expecting, and likely significantly positioned for a proximate recession. However, from our perspective, it is not clear that the market is focussing its ‘growth risk’ attention in the right direction.
Over the past two weeks, the biggest threat to growth has not likely come from inflation or the tightening of financial conditions as a function of the central bank reaction functions to inflation, but in our view, the deepening energy crisis in Europe. Markets have been very keen to price demand destruction from Fed in restrictive territory - some even arguing that the Fed are trying to engineer a recession and increase unemployment, rather than to try to facilitate a better balance in the demand and supply dynamics of the economy (particularly but not singularly the labour market), the latter does not necessarily require the former.
The key fact in my mind is still that private balance sheets, both on the household and corporate side, remain strong. At the consumer level, recent strong job and wage growth add to the pandemic savings buffer and Corporate America has a very strong balance sheet - one where overall leverage is low and there are very low refinancing needs within the next two years. Labour markets will be the battleground for the Fed’s inflation fight, but the fact that the supply/demand mismatch in the labour market is driven by excess demand for labour should be more supportive of the prospect of a soft landing if tighter financial plans shelve expansion plans in the near term (of course this would also likely mean lower investment).
Previously we also discussed the prospect that lower rate vol., as a result of the Fed regaining control of the inflation narrative - or at least lower spread rate vol., and thus uniform global risks to the outlook, had brought forward the likely proximity of a USD peak. However, lower spread vol (consistent with a more uniform or ‘full’ pricing of central bank reaction functions into respective curves), a more stable equity backdrop and ultimately the beginnings of a weaker USD must by default be contingent on a stable idiosyncratic risk backdrop.
The most notable event over the past weeks has been anything but that, namely the deterioration in the energy security of Europe - Flows have halved from already disappointing levels over recent weeks [Nord Stream 1 gas flows from Russia to German are now at only 40% - a sharp reduction relative to early June]. At the same time Europe is having to nationalise or take stakes in energy suppliers at an alarming rate yet analysts retain surprisingly resilient economic forecasts in the eurozone over coming quarters. Especially relative to the US.
A quick eyeballing of the EURUSD chart over the past month or so will show EUR having three distinct dips below 1.05 - each driven by the expectation of, and subsequently the reality of Russian energy curtailment to Europe and the prospect of a substantial hit to economic activity – The latest, most significant EUR drop on the substantial gas pipeline cut taking EUR down near parity at the close of this week – helped by the likely existence of substantial options barriers. Indeed, in the FX market, the combination of our more positive than consensus view of US economic activity (a view that maintains a more positive outlook on US equities as well as US consumption) and our rising concerns about acute, energy supply contingent risks to european economic prosperity (at least in the near term). Germany and Italy, most reliant on Russian gas supplies, are now almost certain to see technical recession in H2 as a result as higher gas prices reduce production (and likely consumer demand) and add to EUR price pressures.
I am still very much of the view that the USD is overvalued and that we are ultimately near a turn in the USD – a prospect that may become more proximate if we begin to see a turn in US inflation – Next week’s CPI print will be closely watched in that regard. However if US economic outperformance and Fed monetary policy widening relative to the rest of G10 continue then the USD can continue. We note the events that led up to the Plaza Accord in 1985, when inflation, US economic outperformance and safe haven status drove a USD rally that was only undone by a cartel of DM central bank interventions.
Of course there are a number of differences to the situation in the eighties when compared to today, but it is also true that in many EM nations, central banks or Ministries of Finance are already directly intervening through rates and or direct sales, to try to prevent further domestic currency weakness and the imported inflation that brings - especially to the commodity importers.
Indeed commodities themselves are a very interesting case in point in global macroeconomic uncertainties at the current juncture. Markets certainly appear to be pricing in significant risks of global recession with significant slumps in Copper (more traditionally aligned to the economic than monetary cycle), Iron ore and even wheat over recent weeks. However, it is not clear that a recession will originate in the US, increasingly less clear that it will be driven by China - as lockdown easing drives a rebound in domestic manufacturing and service sector activity and very high prospect of significant consumer focussed stimulus in the second half of 2022, support the rebound.
In short, while further USD strength may ultimately prove short lived – credible analysis of the impact of severe gas disruption to Europe last month projected a move to around 1.02-1.00 based on technical, skew and valuation - these moves can overshoot and thus standing in the way of the current dynamic is likely a low Sharpe ratio trade in the near term.
Ultimately, however, while sentiment appears to be turning more negative on the global economic backdrop at current levels, we retain a more positive outlook. The key to this discrepancy may be that the prospective ‘recession’ that markets fear is poorly defined. Moreover, it is also likely that the geographical risks of demand destruction are poorly allocated (at least as far as consensus forecasts). Indeed, to paraphrase Depeche Mode, markets are at risk of using the wrong theory on the wrong economy!
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FOMC Meeting, June 2022 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220615.htm
Semiannual Monetary Policy Report to the Congress 22, June 2022 - https://www.federalreserve.gov/newsevents/testimony/powell20220622a.htm
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