The boy who cried wolf

May 19, 2023

A political fable is playing out on Capitol Hill.

Key points

  • The debate over the US debt ceiling dominated headlines this week, but most investors believe that a default will be avoided.
  • There has been some evidence of both slowing global economic activity and progress in reducing inflation; we expect a technical recession by the end of this year.
  • We see the Eurozone roughly six months behind the US in this economic cycle and expect the ECB to hike rates twice more to 3.75% by the end of the summer.
  • In the UK, recent data releases point to impending stagflation, while many are wondering how the country will fare under a Labour government.
  • The big stories in emerging markets this past week were Erdogan’s surprisingly strong showing in the Turkish elections and the revelation that South Africa appears to have been supplying arms to Russia.


Global financial markets continued to remain relatively range bound over the past week. In the US, debate continues to rage over the US debt ceiling, with the sense that we are now within one month of the ‘X date’, when the Treasury is set to run out of cash.

For some time, we have thought the dysfunctional nature of politics on Capitol Hill would mean that negotiations would inevitably go down to the wire, with factions within the Republican and Democrat parties seeking to score a political advantage over the other.

It is possible that a stop-gap agreement will be implemented to kick the can down the road until September, but ultimately there will need to be some compromise on both sides of the aisle, and history suggests that this may only be achieved following a period of elevated stress.

However, for now, financial markets remain relatively sanguine about the upcoming debt ceiling. Measures of market volatility have been moving lower as markets track sideways and it appears that there is a widespread acknowledgement that when all is said and done, the US Administration won’t possibly allow itself to default on its debts and wreak havoc on the global financial system.

In a sense, having witnessed past skirmishes related to the debt ceiling, there is a sense of the story of the boy who cried wolf too many times. It seems for now, markets remain nonplussed. However, we would note that it has been possible to sell one-year CDS default protection on the US at a spread of 170bp, which is more in line with more lowly-rated emerging markets.

In our opinion, it seems likely that anxiety over the debt ceiling may rise over the next several weeks, as the clock ticks down. However, if this does lead to a flight to quality, then this could offer an opportunity to fade these moves, at extended levels.

Meanwhile, a backdrop of low volatility has seen systematic funds adding to long exposures in equity markets over the past several weeks. By contrast, the backdrop in the credit market has been much more mixed, with index spreads tracking wider and primary market issuance failing to deliver much performance. Taking a step back, it appears there is some growing evidence of economic activity cooling and we continue to look for a technical recession, with growth at a standstill, by the end of this year.

For now, we think this slowing in activity will be more gradual than abrupt, as the effects of past monetary tightening continue to feed through. Meanwhile, we still have a sense that progress in bringing inflation lower could prove slower than many hope. In this context, we think we are unlikely to see rate cuts until the end of the fourth quarter this year.

So, if markets move to discount a more premature easing of policy in the interim, then we may be persuaded to take an opposing view. Nevertheless, with markets still pricing in some risk for a further hike at the June FOMC, and with only 50bp of cuts discounted at the end of the year, we don’t think current market pricing is too far from a fair valuation point.

In the Eurozone, markets have also been relatively quiet of late. We continue to see the Eurozone roughly six months behind the US in this economic cycle and see the ECB hiking rates twice more to 3.75% by the end of the summer. This is broadly in line with what is discounted in markets.

Similarly, we think that inflation may prove ‘downwardly sticky’, with wage growth remaining robust and the labour market in the region yet to show any real sign of turning. From this point of view, we think it will be unlikely that we see rate cuts in the Eurozone until this time next year.

A narrowing of the US/EU rate differential, lingering issues in US regional banks and concerns over the debt ceiling have all been reasons for us to favour the euro relative to the dollar of late. We think a move in the direction of 1.15 remains more likely than a slide back towards parity on EUR/USD and so retain a moderate USD short stance.

In the past week, further disappointing data from China has led some to question whether this will hurt the euro’s prospects. Indeed, we ourselves have been flagging that we see scope for structural underperformance of the Chinese economy under Xi and ongoing moves in the direction of deglobalisation, which will also limit Chinese economic potential in years to come. However, we still think that the euro can perform, notwithstanding this. The bloc does not need to be solely reliant on German exports to China, in order to sustain demand.

In the UK, recent data releases appear to confirm to us a path of stagflation. The UK labour market is starting to soften, but wages remain strong and inflationary expectations appear to have shifted to a level well above the central bank target.

Consumer stress is increasing, with a growing percentage of households (over 10%) who are behind on their mortgage payments or in arrears on their rent. Sadly, this seems set to grow. It is striking to note how many conversations one can have with those removed from the financial industry, who are only just beginning to appreciate what higher interest rates and higher bills are meaning for their family’s finances.

When choosing between slumping growth and high inflation, we think that the leadership of the BoE walks a path down the middle. They will hope that inflation self corrects, while hoping the economic backdrop does not get too bad.

Yet the strategy of hoping for the best on inflation certainly has not worked to date and we are sceptical that this will be the case going forward. We still see the net result of these policies pointing towards a weaker pound over the medium term.

One other area of interest in the UK is in looking forward to what a Labour government may mean. In discussion, we get a sense on Europe that Labour will sell a message of ‘making Brexit work’. This can be read as a desire to move to a point of more frictionless trade, and a relationship with the continent which more closely represents a Norway-like deal.

However, we think it will be important for Labour leadership to engage with EU counterparts before announcing their position, and it could be hoped that the arrogance at the Tory approach to discussions with Brussels can give way to a much more partnership-based model that seeks to re-build lost trust.

Ultimately, we think that the UK may make a full return as an EU member – but this would be something that could be on the table in a second or third term Starmer Administration. Yet this remains a long way off, and we are also concerned that the parlous state of the UK economy at the likely time when Labour takes over is going to mean that they inherit a very challenging mandate.

Elsewhere, inflation data in Japan continues to build to the upside, as shown by this morning’s CPI print which showed a reacceleration to 3.5%. We think that the BoJ is being much too slow to appreciate that the objective of stable inflation at 2% has now been attained, and that the longer they delay normalising policy, so the risks of a more extreme inflation overshoot will start to grow.

On this point, it was interesting to note comments from Cabinet Secretary, Matsuno, this week, suggesting that major power companies would be permitted to raise electricity prices between 14-42% effective from June. This is likely to see a further jump in CPI.

In turn, we believe that this will continue to support robust wage demands in a relatively tight labour market. Much of this seems reminiscent of what we have seen in the US and Europe over the past several years, yet we think that there is a blind spot in Japan when it comes to inflation risks, with the country having been mired in a deflationary mindset for so long.

However, this is rapidly changing, and we think that Ueda could be making a mistake if he is too slow to respond to this, by beginning to normalise ultra-accommodative policy soon.

Meanwhile in emerging markets, Turkish elections have seen a surprisingly strong result for Erdogan, who appears set to retain the Presidency in a second round run-off. This may mean a continuation of a policy mix, which we think is unsustainable, and we consequently see scope for a materially weaker currency and growing risks of debt default in the course of time.

Otherwise in Africa, news that South Africa appears to have been supplying arms to Russia comes at a time when sentiment towards the country is already depressed, thanks to political scandals and failures in the power network, which has seen widespread load shedding and a desire from households and companies to move ‘off-grid’.

The ANC has always been sympathetic towards Russia, dating back to its time as a banned party under apartheid. However, it will be important that it can demonstrate its neutrality, if it is not to find itself on the wrong side of the divide. For now, we may hope that any sanctions will be limited.

Meanwhile, we get the sense that the US does not want to surrender the continent of Africa to China, and this may encourage a more conciliatory stance.

Looking ahead

As we move towards the end of May, further data and developments in Washington may dominate price action. For now, we think there is a sense of patience. Markets are calm for now, but we are sceptical as to whether this will persist for too long.

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