How the markets scan America, the UK, Germany and Türkiye
The US debt ceiling debate has dominated the headlines this week, but most investors believe a default will be avoided. Point by Mark Dowding, Fixed Income CIO, RBC BlueBay AM
Global financial markets continued to remain relatively range bound last week. The debt ceiling debate continues to rage in the US as we are now one month away from “date X” when the Treasury is set to run out of liquidity.
We thought for some time that the dysfunctional nature of politics on Capitol Hill would mean that negotiations would inevitably stall, with factions within the Republicans and Democrats trying to gain one political advantage over the other.
A tentative deal may be implemented to buy time until September, but eventually a compromise will need to be reached by both sides, and history suggests that this deal can only be reached after a period of severe stress.
THE OPTIMISM OF THE MARKETS ON THE DEBT CEILING
However, for now, financial markets remain relatively optimistic about the next debt ceiling. Measures of market volatility have eased as markets move sideways and there seems to be a widespread understanding that, ultimately, the US administration cannot afford to default on its debt and wreak havoc on the system global finance.
For now, the markets appear to be unsurprised. However, we note that default protection on US 1-year CDS could be sold at a spread of 170 basis points, more in line with lower-rated emerging markets.
Meanwhile, an environment of low volatility has seen systematic funds increase their long exposures to equity markets in recent weeks. By contrast, the credit market was much more mixed, with index spreads widening and primary market issuance underperforming. Stepping back, there appears to be growing evidence of a cooling in economic activity and we continue to forecast a technical recession, with growth stagnating, by the end of this year.
For now, we believe the slowdown in activity will be more gradual than abrupt, as the effects of past monetary tightening continue to play out. We believe that progress in reducing inflation may be slower than many hope, and against this backdrop, we believe we are unlikely to see rate cuts before the end of the fourth quarter of this year.
Therefore, if markets were to price in a more premature monetary policy easing in the meantime, we might be persuaded to take the opposite position. However, given that markets continue to price the risk of a further hike at the June FOMC and that only 50 basis points of year-end cuts are priced in, we believe the current market price is not too far off a valuation point. fair.
QUIET MARKETS IN THE EUROZONE
In the Eurozone, markets have also been relatively quiet lately. We still believe the eurozone lags the US by about six months in this economic cycle and expect the ECB to hike rates twice more to 3.75% by the end of the summer. This is substantially in line with what the markets discount.
Similarly, we believe inflation could be “sticky to the downside” as wage growth remains robust and the region's labor market has yet to show any sign of improvement. From this perspective, we believe it is unlikely that we will see rate cuts in the Eurozone until next year.
Narrowing US-EU rate differentials, ongoing problems with US regional banks and debt ceiling concerns are all reasons that have led us to favor the euro over the dollar in recent times. We believe a move towards 1.15 is more likely than a return to parity on the EUR/USD pair and therefore we maintain a moderate short position on the dollar.
DISAPPOINTING DATA FROM CHINA
Over the past week, more disappointing data out of China has caused some to question whether that could hurt the euro's prospects. Indeed, we ourselves have signaled the possibility of structural underperformance of the Chinese economy under Xi's leadership and continued moves towards deglobalization, which will also limit China's economic potential in the coming years. Despite this, we continue to think that the euro is capable of performing. The bloc must not depend solely on German exports to China to support demand.
STAGFLATION IN THE UNITED KINGDOM
In the UK, recently released data appear to confirm a path of stagflation. The UK labor market is starting to soften, but wages remain solid and inflation expectations appear to have moved well above the BoE's target.
Consumer stress is on the rise, with an increasing proportion of households (over 10%) in arrears on mortgage or rent payments. Unfortunately, this situation looks set to increase. It's amazing how many conversations one can have with people outside the finance industry, who are only just beginning to realize what higher interest rates and higher bills mean for their family's finances.
In choosing between slumped growth and high inflation, we think the Bank of England's executives are taking a middle ground: in the hope that inflation will correct itself, and that the economic backdrop won't get too negative.
However, the strategy of hoping for the best with regards to inflation has not worked so far and we are skeptical that it will do so in the future. However, the net result of these policies seems to us to be oriented towards a weaker pound over the medium term.
Another area of interest in the UK is the prospect of a Labor government. During the discussions, we get the impression that Labor will be selling the message of 'making Brexit work'. This can be read as a desire to move to a point of greater trade friction and a relationship with the continent that more closely represents a similar arrangement to Norway.
However, we believe it will be important for the Labor leadership to engage with their EU counterparts before announcing their position, and one could hope that the hubris of the Tory's approach to discussions with Brussels could give way to a very more based on partnership, seeking to rebuild lost trust.
Ultimately, we believe that the UK can rejoin the European Union, but this could be something to consider in a second or third term of the Starmer administration. However, that is still a long way off and we also fear that the state of crisis in the UK economy by the time Labor takes power will mean they will inherit a very challenging mandate.
GOOD INFLATION IN JAPAN
In Japan, inflation data continues to be positive, as evidenced by this morning's CPI data, which reaccelerated to 3.5%. We believe the BoJ is too slow in realizing that the stable 2% inflation target has now been achieved and that the longer policy normalization is delayed, the more the risks of an inflation overshoot increase.
In that regard, it was interesting to note comments from Cabinet Secretary Matsuno this week, who suggested that major power companies would be allowed to hike electricity prices between 14 and 42 percent from June. This is likely to lead to a further increase in the CPI.
In turn, we believe this will continue to support strong wage demands in a relatively tight labor market. All of this is largely reminiscent of what we've seen in the US and Europe in recent years, but we believe there is a blind spot in Japan when it comes to inflation risks, given that the country has long been mired in a mentality. deflationary.
However, the situation is changing rapidly and we believe Ueda may be making a mistake if he is too slow to react to this situation, starting to normalize the ultra-accommodative policy early.
WHAT ABOUT EMERGING MARKETS?
Meanwhile, in emerging markets, the Turkish election saw a surprisingly positive result for Erdogan, who looks set to retain the presidency in the second round of the ballot. This could mean the continuation of a policy mix that we deem unsustainable, and as a result we see the possibility of material currency weakening and increasing debt default risks over time.
In Africa, the news that South Africa appears to have supplied Russia with arms comes at a time when sentiment towards the country is already depressed, due to political scandals and power grid failures, which have seen widespread cargo shedding and the desire of families and companies to move "off-grid".
The ANC has always had sympathy for Russia, from its days as a banned party under apartheid. However, it will be important that you demonstrate your neutrality if you don't want to find yourself on the wrong side of the fence. For now, we can hope the penalties are limited.
Meanwhile, we have the feeling that the United States does not want to cede the African continent to China and this could encourage a more conciliatory position.
LOOKING AT THE FUTURE
As the end of May approaches, further data and developments in Washington could affect the price action. For now, we believe a sense of patience remains. Markets are calm for now, but we are skeptical that this situation will continue for long.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/mercati-tetto-debito-stati-uniti/ on Sun, 21 May 2023 05:40:13 +0000.