The R word

The R word

“Why do economists use decimal points in their forecasts? To show that they have a sense of humour” is a joke that resurfaces in the marketplace every time volatility picks up. There’s some truth in this. Things rarely move consistently in one direction. So incrementally tracking how they’re unfolding is useful. But sometimes there are bigger discontinuities. Last Thursday, we moved to euro area/UK recession as our new base case. Our asset allocation team is now neutral equities – favouring, within them, US over euro area equities, and emerging markets over global equities. And neutral bonds – favouring, within them, emerging market sovereign hard-currency bonds over low-yielding government bonds. Last Friday, the purchasing managers’ index (PMI) for the euro area fell below 50, pointing to recession. The PMI fell below the threshold separating expansions from contractions also in the US, though the overall situation looks worse in the euro area. The dataflow will likely be confusing for some time. US GDP growth was negative in Q1, driven by inventories/net trade – domestic demand was more resilient. So, perversely, the US is closer to a ‘technical’ recession (two quarters of contraction) than the euro area, which did grow in Q1. What if quirks in the data trigger another negative US GDP print in Q2? Is the US, which is running at full employment (though the labour market doesn’t lead the cycle), with well-capitalised banks and solid private-sector balance sheets, in a ‘true’ recession while the euro area isn’t? Here’s why we don’t think so.

Winter is coming sooner in some places: Recession is now our base case for the euro area and the UK. Rising costs in both and likely gas rationing in the euro area are squeezing incomes. We expect the euro area to shrink for three quarters as gas rationing is probable even now that the Nord Stream 1 pipeline has partially resumed. The energy ‘price cap’ mechanism in the UK is likely to increase utility bills and, along with more rate hikes than initially thought, will probably trigger a two-quarter contraction. In both, the timing and magnitude of recession are unusually uncertain. The US is slowing too, but the deceleration has to do with the Fed. So, if warranted, the central bank could slow/stop the tightening cycle – or even ease policy – when inflation is more under control. So we think the probability of US recession over 12 months is lower vs the EU/UK, although it’s not low and looks set to increase at longer horizons as the housing market is weakening. China’s reopening and stimulus are boosting growth and reducing recession odds to one in five. However, while not yet cause for alarm, Covid infections are rising again and so lockdown risks remain.

The stuff that’s (hopefully) peaking: Inflation seems to be peaking in the US – though at a high level – but not yet in the EU/UK. US core inflation (ex energy and food) and wage growth, on a year-on-year basis, have both slowed for three months in a row. Market-based inflation expectations are beginning to roll over and, while a very recent trend, business and to some extent also consumer surveys are pointing to slightly more moderate price pressures as demand slows and supply adjusts. EU/UK inflation is still rising on energy/supply strains. While the risk is that it takes longer, we now see it peaking towards year-end as policy tightens, demand falters and spare capacity widens. Ex gas, commodity prices are declining. We don’t expect consumer prices to fall. Rather, we think inflation is likely to moderate while staying higher than the abnormally low levels of the 10-15 years of austerity/balance-sheet repair pre-Covid. Bond yields appear to have peaked at relatively low levels vs past cycles, in line with our call. We expect the euro to fall back below parity vs the US dollar as the ECB is unlikely to hike as much as the Fed. Further out, we project rate cuts.

Here’s why this matters:

How’s our asset allocation changing? Our tactical positioning has recently turned neutral equities (i.e., in line with our long-term positioning). But we keep two relative equity positions: US vs euro area equities and emerging markets vs global equities. With recession now our base case in Europe, the stubbornly high earnings per share (EPS) expectations for euro area equities are likely to become increasingly challenged especially relative to EPS expectations for US equities. Another recent change is that we closed our US investment-grade underweight, as spreads have widened to above their long-term averages, making the forward-looking prospects for this asset class more appealing. This change took us back to neutral duration. Our asset allocation team continues to remain overweight emerging market sovereign hard-currency bonds against low-yielding government bonds.

What position will euro area equities be funding at the portfolio level? We used the proceeds from selling euro area equities to fund our continued overweight in US equities. Our asset allocation team sees US equities as a high-quality asset class. They prefer US to euro area equities for several reasons. Importantly, the more positive EPS upgrades for euro area vs US equities, coupled with the similar returns year-to-date, is something we believe will be increasingly challenged by investors. Additionally, our equity strategists find the sector mix, based on a proprietary model, much more attractive for a tactical US equity overweight vs euro area equities. Finally, historical analysis shows that US equities have tended to strongly outperform euro area equities when growth slows. If a global/US recession were to materialise, this position would hedge that risk.

Meanwhile, no summer lull in sight…

Policy & politics in the spotlight: It’s a big week for tech companies, with Apple, Microsoft, Meta and Amazon all reporting Q2 earnings – a crucial catalyst for US equities. While the Fed could hike rates by 100 bps this Wednesday, we think it’s more likely that we’ll see a second 75 bps hike to 2.50% – the ‘neutral’ rate above which monetary policy has contractionary effects. Later today, the German Ifo business climate should revel extra weakness. The market may focus on the Q2 GDP reports for the US (Thursday) and the euro area (Friday), although they’re backward-looking. Last week, the ECB raised each of its three key rates by 50 bps, ending the negative-rate policy. Mario Draghi’s resignation as Italy’s Prime Minister triggered a snap election scheduled for 25 September. Given rising political volatility in Italy, we suspect that the new ECB anti-fragmentation tool to mitigate sovereign spread widening may be tested before long. Euro area inflation for July (Friday) is likely be widely scrutinised by investors to assess whether the recent decline in oil prices is beginning to feed through, though it’s quite possible that the core measure may have increased again. US PCE inflation (Friday) is for June, so it will likely paint a somewhat outdated picture: it should reveal past increases in energy and services prices, even though gasoline prices fell recently.

Daniele Antonucci | Chief Economist & Macro Strategist

This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down.

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