Daily Comment (December 16, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Today’s Comment begins with our thoughts about European fragmentation. Next, we discuss how countries within blocs may prioritize their own self-interests over others within their group. Lastly, we review signs that the global economy may enter a recession in 2023.

 Fragmentation Returns: The bond market is unsettled with the European Central Bank’s plan to wind down its balance sheets and accelerate rate hikes

  • The ECB is poised to ramp up its tightening cycle in 2023 as it looks to combat inflation. On Thursday, ECB president Christine Lagarde announced that the central bank planned to raise interest rates higher than the market anticipated and wind down its balance sheets starting in March. The bank plans to hike rates in 50 bps increments and reduce its balance sheet by 15 million euros per month, on average, until the end of the second quarter of 2023. When explaining the need for the aggressive decision, Lagarde argued that the ECB has more ground to cover to catch up with the Fed.
  • The market responded negatively to the ECB’s hawkish tone. The Euro Stoxx 50 closed down 2.6% on Thursday. Meanwhile, the 10-year yield on Italian bonds jumped 25 bps, pushing its risk premium above the German 10-year bond by 207 bps. The market reaction suggests that investors would like to receive more yield from retaining riskier assets. That said, the central bank’s tough talk did help boost the EUR. The currency peaked at $1.0737, its highest level since June 9, as investors believe that the ECB is prepared to take on inflation.
  • At this time, the ECB may not actually be able to tighten policy as much as it claims. Tightening monetary policy aggressively creates diverging borrowing costs among eurozone countries. Differing interest rates will make it harder for the European financial system to operate as a single entity. Although the ECB has developed anti-fragmentation instruments to address these issues, committee members are reluctant to use those tools. As a result, it is more likely that if bond spreads get too out of whack, the ECB could moderate its policy stance.

Friend or Foe? Inter-bloc rivalries may undermine efforts to form regional blocs and could lead countries to become isolationist.

  • The U.S. and the European Union are still at loggerheads over the “made-in-America” provision in the Inflation Reduction Act. The law allows U.S.- based firms to receive a tax break if they source materials from American suppliers for parts used to make goods such as electric vehicles. France believes that the regulation will disadvantage European companies. Meanwhile, American think tanks posit that the bill will help the U.S. compete with China. The dispute could turn into a trade war between the U.S. and Europe and undermine efforts to integrate economic and foreign policies.
  • Things are not any better in the potential Chinese-led bloc. India has purchased Russian oil under the G-7 price cap. Before the cap was established, Russia insisted that it would not supply countries who complied with the rule. Additionally, China has banned the sale of military-grade processors to Moscow in order to comply with U.S. sanctions. The decision by India and China to follow western sanctions on Russia suggests that countries may not be loyal to their bloc if it goes against their respective interests.
    • This could potentially have geopolitical implications as smaller blocs may form within larger blocs. For example, OPEC countries (who are generally aligned with China) could respond by reducing production, thereby harming other members of the China-led bloc.
  • The interwar period between World War I and World War II was the last time countries were truly deglobalized. Although there were military alliances, the lack of a definitive reserve currency made it difficult for countries to maintain trade blocs. As a result, countries were very centralized, and global trade was relatively limited when compared to pre-WWI. As the U.S. withdraws from its position as a global hegemon, other countries may seek to also disengage from the rest of the world. This scenario could lead to higher inflation, which should benefit commodities. As the chart below shows, commodities generally perform well relative to stocks in an inflationary environment.

(Source: Longtermtrends.com)

Warning Signs: There are mounting signs that the global economy may have a rough ride in 2023.

  • U.S. economic data shows that the world’s largest economy is slowing down as retail sales and manufacturing dropped in November. The weak economic data shows that consumption and production are waning, adding to woes that the U.S. may be headed toward recession over the next few months. Additionally, firms are becoming wary of the number of workers on their payrolls, and even government agencies are feeling the pinch. As a result, unemployment numbers may rise next year as firms adapt to a decline in demand.
  • The COVID spread in China also poses a risk to the global economy. As Beijing slowly starts to reduce its Zero-COVID restrictions, the death toll is beginning to surge. The spread of the virus will make it difficult for the world’s second-biggest economy to purchase global goods and could further complicate supply-chain flows. As a result, international firms could take a hit in revenue and see an uptick in their input costs. Although the drop in Chinese demand could weigh on global inflation, it is also possible that it would make it harder for countries reliant on exports to grow their economies.
  • Lastly, there is still rising uncertainty about how major central banks will adjust monetary policy during a recession. Although it is tempting to assume that they will abandon tightening when the economy weakens, the central banks are mandated to reduce inflation to around 2%. Given that these banks aim to maintain unemployment and price stability, it wouldn’t be unreasonable for them to keep rates elevated even when the economy is in recession. As a result, we advise that investors be strategic in their allocations and pay closer attention to shorter-duration assets until the Fed signals that it is prepared to ease monetary policy.

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