Quick in the transition

And not just in football….

Core government bond yields moved lower in a choppy week for markets. Risk assets were relatively stable following last week’s bank-led flare up, while the US dollar was somewhat firmer. However, rather than a sense of security, we think the state of play in markets expresses the degree of uncertainty among market participants grappling with risks on several fronts, while interpreting late cycle economic data.

In general, we wouldn’t be surprised if volatility picks up in the months ahead – so being patient and waiting for clearer opportunities seems to be the stance best warranted.

On the data front, the US labour market remains surprisingly resilient, with unemployment falling to 3.4%, a 50-year low, while monthly nonfarm payroll additions continue to run at a healthy clip (200k+). On inflation, April’s CPI report showed some progress, with headline data falling below 5% for the first time in two years.

However, with core measures still above 5%, and trending sideways, there remains uneasiness in some quarters as to whether policy is sufficiently restrictive to deliver the 2% target over the medium term.

US interest rate markets currently discount approximately 75bp of cumulative Fed cuts by December. This may appear overly optimistic, given the tightness of the labour market and subsequent pass-through into wages and services inflation.

Moreover, fears of an imminent recession are in contrast to recent corporate earnings and consumer strength. The first quarter earnings season was strong by historical standards, with guidance and bottom-up estimates upgraded, while a recent Fed paper suggests that excess household savings are still abundant and able to support spending until year end.

That said, there is now more widespread evidence that restrictive monetary policy is slowing growth, evidenced in the Fed’s latest Senior Loan Officer Survey, which showed further tightening in lending standards in the first quarter.

Moreover, ongoing turmoil in regional banks threatens a tightening of financial conditions, which will gradually slow economic activity as we progress through the year. If there is a sudden and abrupt slowing of activity, and if inflation is also seen to be behaving, so the Fed now has plenty of room to lower interest rates, as and when the time is appropriate.

With interest rates above 5%, this level is now well ahead of perceptions of a neutral rate. Consequently, any monetary easing could progress in clips of 50bp at a time, or even faster, were the conditions to warrant this.

An impending debt ceiling drama is also hindering sentiment. This week, speaker of the House, McCarthy, met with President Biden for further talks but to no avail, with Biden even flirting with the idea of invoking the 14th amendment (which would be legally messy). It seems sadly predictable that brinkmanship will go to the final hour, as Republicans and Democrats seek to score points from one another.

However, there is a real risk that the deadline for when the Treasury runs out of cash is actually passed, on this occasion. Should this occur, possibly as early as the start of June, we would be confident that the Administration would prioritise debt payments in order to avoid a default and the resulting chaos in financial markets. We would be generally cautious on the outlook for risk assets until this can be resolved.

In Europe, recent German factory orders and industrial production data came in softer than expected, as Germany continues to transition the structure of its economy to lean more towards services. Something to keep an eye on, but broadly speaking, the European economy remains in a relatively healthy position.

Moreover, with wage growth elevated, and consumer inflation expectations rising, there is no sense from the ECB leadership that a pause is imminent, and we continue to expect deposit rates to rise through the summer.

The impact of recent social instability in France was widely ignored by financial markets but last week credit agency, Fitch, downgraded the country one notch to AA-, primarily citing concerns around weak fiscal metrics against peers, but also a weak growth outlook and political unrest which is hampering structural reforms.

Current debt/GDP stands at 112%, the highest among 'A' rated peers, and based on latest plans put forth to the EU, fiscal consolidation will largely depend on growth of above 1.5%+ annually over the next several years, which seems highly ambitious given the current monetary policy outlook and possibility for weaker global growth going forward.

These targets will be much tougher if the EU adapts a 1/20 per year falling debt/GDP rule once the Growth and Stability Pact is revised and reinstated. In that respect, France as a credit stands out like a sore thumb among ‘semi-core’ peers such as Belgium, Finland, Netherlands, and Austria.

In the UK, the BoE hiked rates 25bps to 4.5% as expected, with revisions to the growth forecast ruling out a recession in the near-term. However, with headline inflation still above 10%, real rates are still in deeply negative territory.

As we have noted in the past, the BoE’s reluctance to be more forceful in policy and lack of desire to bring inflation down towards target lies in the trade-off with financial stability and growth, most evidently through the impact on the housing market which has yet to be fully digested.

Moreover, by framing the inflation problem as a ‘cost-of-living crisis’, wages continue to catch up, exacerbating the price setting spiral. High frequency wage data from consultancy, Reed, showed wages growing at 10% year-on-year, higher than some official figures, with some places such as Blackpool and Milton Keynes enjoying 20%+ rises.

We continue to struggle to see how the BoE will effectively manage price stability, growth and financial stability over the coming months, with the likely release valve a weaker pound going forward.

In FX, the dollar has been stable near the lows of the year. However, the story of the week has been continued compression of volatility in FX, with the relentless hunt for carry unabated. We remain skeptical of this – the forward-looking returns for carry tend to be negative when volatility is this low, most carry currencies screen poorly on valuations and are lacking any risk premium, and there are lingering concerns around US recession/banking stress/debt ceiling/weak Chinese growth.

In EM, this coming weekend will see Turkish Presidential and Parliamentary elections held in what will be a defining moment for the country. The outcome is largely seen as a binary one for credit markets, with a win for President Erdogan likely to see a selloff in Turkish assets, while an opposition victory would like to see a rally as markets look for a more orthodox policy framework to be implemented.

Corporate spreads are largely flat over the week, having slowly leaked wider over the month of May. The same drivers, including US recession fears/US regional banking stress/US debt ceiling negotiations, are all dictating the sentiment in credit and leave yields at close to decade highs given the dynamic of both higher government bond yields and wider credit spreads.

Within credit, financial versus non-financial sector relative value remains elevated, given the turmoil within the US regional banking system which continues to be under pressure. We would reiterate that, generally speaking, banks are in a healthy position and are supported by solid interest margins and a relatively benign backdrop for credit quality.

While there is no doubt that US regionals will remain under pressure, in particular as consolidation and increased regulation play out over the quarters and years ahead, we would disagree with any notion that we are witnessing developments which are more broadly systemic.

Looking ahead

We sense a malaise in markets looking for a breakout in a more decisive direction. On the one hand, a full-blown credit crunch facilitated by tighter bank lending risks a more rapid and premature slowing of economic activity, thus bringing forward a possible Fed pivot.

On the other hand, recent economic data is displaying strength, and the narrative could easily shift in the direction of the Fed needing to do more on rates to get inflation under control. We therefore have low conviction in the macro backdrop but are biased to expect more volatility and a period of risk-off in markets, as potential risks come to the fore.

This week saw an epic tactical battle between arguably the two best football sides in the world, with both managers, Ancelotti and Guardiola, masters of the ‘transition’ in football jargon. The term refers to the moment when one team regains the ball, and by doing so springs a quick, co-ordinated action to take advantage of the opponent's temporary, disorganised state.

The saying could also ring true for the current market environment, where being patient and springing into a ‘transition’ once markets are in a more volatile state might just be the best course of action…