The Fed has now hiked the Fed Funds Rate 50-basis points in May and then by a further 75-basis points in June in its effort to fight inflation, and another 75-basis point hike is broadly expected at the July meeting given current member rhetoric about the ample ability of a robust economy to handle it (supported by a strong jobs report). Across the Atlantic, the ECB is also poised to tighten, but will do so into a weakening economic environment with a brewing cost of living crisis and against the risk of fragmentation, not to mention the very real threat of Russia closing the spigot in retaliation for sanctions relating to the war in Ukraine.
Through the Covid crisis and recovery there has been much talk of the quasi-conflicting nature of the Fed’s dual-mandate of price stability vs economic growth. However both rest upon the preservation of healthy financial conditions and thereby the maintenance of a fully-functioning financial system - which includes markets. There, the narrative has moved on from one of “inflation vs recession”, to one of “when will we get recession?” and moreover: “how far can it go before something breaks?”
The pain and uncertainty associated with slamming the monetary machine into reverse is becoming evident everywhere as markets and policymakers grapple with a macroeconomic backdrop that, with faster cycles, rising rates and higher inflation, is already fundamentally changed from that of recent decades. But, whatever shape this new macro paradigm takes, in the short term markets will nonetheless continue to place bets on the steeliness of the Fed’s nerve, while geopolitics (and the US midterms) will weigh in to make it more interesting (and perhaps a little uglier). Optimists remain hopeful that cresting inflation will allow the Fed to come off the brakes before too much damage is done (allowing for some relief in equity markets). However what appears clear is that pre-pandemic ‘normal’ is now firmly consigned to the history books, and things could likely get more interesting (read: volatile) as market participants try and work out the shape of things to come.
Outlook as at 12.7.2022
What have our equity quant indicators been telling us?
In Europe, the very real risk of an energy crisis – which risks hastening and deepening the (inevitable, but not imminent) recession - continues to loom large; as we write the Nord Stream One pipeline is closed for maintenance with much talk of the Russians potentially not turning it back on in retaliation for European sanctions over the war in Ukraine. Financial conditions have tightened but the biggest risk remains the squeeze on incomes that is already evident from higher inflation. The ECB is poised to raise the deposit rate by 25-basis points at its upcoming meeting next week (and this could be followed by a 50-basis point hike in September); it having already announced a faster normalisation of its policy stance and brought asset purchases to an end on 1 July. Our regional equity matrix (our home-spun indicator that gives us a regional view) continues to award European equities a bearish rating: the trend score has improved but remains weak (-71) and sentiment has fallen further
(-20). While a weaker euro should help the region’s exporters, weaker global demand is likely to keep the lid on European exports (with ongoing Covid outbreaks in China also a concern). We would favour defensive, large-cap names (Switzerland) over cyclicals (Germany) in the current environment. See the latest iteration of our European long-only selection here (or on request).
A solid June jobs report in the US means the Fed is likely to brush off recession talk and push ahead with another 75-basis point rate hike at its July meeting. However, it remains the view of our economists that it will moderate the pace of rate increases after the summer, settling on 25-basis point hikes from September until December. The caution ahead of earnings is palpable, with many braced for a slew of downward revisions as ambitious comps, slowing economics and pricing headwinds risk becoming more evident in Q2 reporting (see our earnings preview again here). As we write, our regional matrix is ‘very bearish’ the US with poor trend and sentiment scores weighing heavy on the picture. Playing the earnings season will not be for the faint of heart, however the stronger dollar could give domestic names the edge (while healthcare and biotech are both looking alluring from a technical point of view). See the latest iteration of our US long-only selection again here.
The LDP’s big win in Japan means Kishida’s administration will not have to fight another election for three years, and attentions will turn to his ‘New Capitalism’ agenda and goal to put Japan on a more sustainable growth trajectory (as well as a possible change to the country’s pacifist constitution that could change the geopolitics of the region). A weaker yen continues to reflect the likelihood that the BoJ will continue to defy the global trend, Governor Kuroda signalling again Monday that it will retain its easing stance as he warned of ‘very high uncertainty’. The market has a ‘neutral’ rating in our regional matrix with a healthier sentiment reading than elsewhere, while the monetary differential and the lower yen should still present a tailwind to exporters - for those seeking means by which to gain some exposure to the recovery in Asia.
Emerging markets (heavily weighted China) have emerged from bearish territory and now also have a ‘neutral’ rating in our matrix, the authorities’ ongoing efforts to shore up conditions apparently reflected in the region’s improved liquidity and economics scores. However, our economists remain cautious in light of the expected moderating external demand from developed economies and the persistent zero-Covid policy that continues to put the recovery in domestic demand at risk. The short-term outlook for Chinese equities may have brightened but longer-standing risks remain.
Outlook as at 12.07.2022
The US 10-year Treasury yield has continued its rise with the upward momentum sending it above key resistance at 3.26% (a key level corresponding to the target of the “cup & handle” and the prior high made in 2018), challenging our short-term scenario of a pause at that level, to the psychological 3.5%. It has since come off this high (the 10s2s curve recently inverting once again) and our preferred scenario remains one of consolidation in the second half of the year (which could send the yield back towards the rising support line connecting lows since the start of the year at around 2.8%). A confirmed rise above 3% could nonetheless put the 10-year yield into a new bullish paradigm in our view.
Key views and targets
A sum-up of our core views and targets is presented in our core views table below (click to enlarge). All of our selection lists are also of course available on request.
Find out more
For the most recent updates on our FX convictions, see our latest technical views on equity indices and sectors, and currencies, commodities and bonds, and a short introduction to our quantitative process is available here.
The Trading Strategy Team
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