Top Down

Over the last month, there have been cuts to economic growth forecasts. Although the growth rates are still above trend, the margin is getting small. China and the US have seen the biggest changes. China has been impacted by Covid-related lockdowns, while higher inflation and energy prices hitting consumption has impacted the US. On the other hand, inflation forecasts have been rising leaving nominal growth forecasts virtually unchanged over the last month.

Higher inflation figures have led to changes in interest rate expectations. The announcements from the European Central Bank (ECB) Governing Council’s meeting were more ‘hawkish’ than expected. The ECB will be tightening policy starting in July with the end of bond buying and an interest rate increase of 25bps. What surprised people is that it indicated that if inflation remains the same, there will be a 50bp increase in September and gradual – but continual – increases after that.

Its inflation forecasts also caught people somewhat. It now forecasts inflation to remain above target through to the end of 2024 thus giving it room to increase interest rates more than people expected. Most forecasters were expecting interest rates to peak at 1.5% but that is in doubt now. Another unwelcome feature was no indication of a plan to avoid disorderly moves in parts of the euro area fixed income market (so called fragmentation), and as a result, there has been noticeable widening in peripheral spreads. This weakening in peripheral sovereigns along with shorter duration led corporate debt to outperform.

The US bond market was also weak. There was hope that we had reached the point of maximum ‘hawkishness’ from the Federal Reserve (Fed). A strong inflation reading for May reversed that sentiment and has pushed the Fed to increase the interest rate by 75bps instead of 50bps expected at the start of the month. It is back to talking about the possibility of more hikes of 75bps, speeding up further the process of normalisation.

Equity markets lost another 3.2% since last month’s edition of Top Down. Rising bond yields are not good news for equity markets as they put downward pressure on valuations. There were slight upgrades to earnings over the same period, but they have been concentrated in the commodity sectors and have not been enough to compensate for the higher bond yields. The recent drop in prices has brought the historic valuation below the long-term average, which is supportive, but it will not be enough to change the tone. Until bond markets stabilise, equity markets will find it hard to make progress.

The surprising thing about the recent performance is that the cyclical sectors (Commodities, Industrials and Consumer Discretionary) were the best performing. Normally, if we see nervousness in equity markets, it is the defensive sectors (Healthcare, Consumer Staples and Utilities) that lead. We do expect this trend to emerge as we travel through the rest of the year.