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In a range, which way do we go?

Time for my latest missive, and yes you guessed it, more debate around inflation, interest rates and recession. Treasuries have rallied, with risk selling off over the last week or so, but at least for Fixed Income, we seem to be stuck in a bit of a range as we wait for more data on growth and inflation. It looks like the ECB is now going to raise rates, and we are still expecting 2x50bps from the Federal Reserve over the next 2 meetings.

Earnings are largely behind us, but tech continues to be volatile and under pressure. Some good news this week, which has supported equity markets in the short term. President Biden has said he would review China tariffs with Secretary Yellen upon his return to the US. He also unveiled the Indo-Pacific Economic Framework. In addition, we saw some unexpectedly stronger than expected data from Germany – The IFO Institute business climate indicator came in at 93.0 vs 91.4 expected for May. Unfortunately, that was about it in terms of good news….

So do we actually know anything new? Have we learnt anything significant since my last email two weeks ago? The answer is basically “not really” but we have a few new ideas to consider. The first one is that Federal Reserve market communication is on overdrive. The market collapse post the Federal Reserve meeting on the pullback from a 75bps move saw the 10 year US Treasury briefly reach 3.20%[1] as simultaneous fears over the Fed not doing enough to combat inflation plus a worry that if 75bps wasn’t on the table perhaps they know something we don’t about the strength of the US economy hit investor confidence. Out came several Fed governors to talk us back from the precipice and back we went to around 3%.1

Conclusion 1: the Fed is going to manage expectations and with a dual mandate of inflation and employment, letting yields run to 4% on the 10 year would seem unlikely at this point. Hike hard and fast early and then pause as we head towards mid-terms. This has been our central case.

Conclusion 2: The outlook for China continues to be extremely important both for the global growth outlook and easing of supply chain pressures. The uncertainty around Zero COVID saw sentiment change dramatically, with a complete volte face once it looked like Shanghai would re-open. At the margin, this is driving some of the daily volatility we are seeing in equity markets and government bonds. If we see China restrictions ease and the economy re-open, that will fuel confidence for global growth.

Is there anything that we can say with any certainty? Inflation this strong cannot last ad infinitum. Its likely end will come with a recession. A soft landing without recession aka 1994 is unlikely, and irrespective of that losses in 2022 are already significantly higher than the -3.4%1 for the Bloomberg US Treasury Index and -1.5%1 for the S&P according to Bloomberg data.

A recession, however, need not be a hard landing. The one difference this time, is that this is COVID shutdown induced inflation. It is supply rather than demand driven. This is why China is important – open up and we could see alleviation of some of those pressures. We are already seeing some signs that inflation is coming down as consumers switch from durables to services. We are also likely to see the strength in services begin to reduce after this summer travel season.

So what is it the market fears if we are already seeing peak inflation year on year? The fear is that with such a strong labour market in the US, whilst it is a sign of the robustness of an economy that can withstand a series of aggressive rate hikes, it also means inflation being baked into higher wages, which in itself feeds the inflation spiral. Expectations of higher wages feeding into higher prices and forcing the Fed into higher rate hikes. This will result in stickier and higher inflation even once the transitory effects around supply chains dissipate. The Fed moving rates too far resulting in higher unemployment and thus recession is exactly what the markets fear. Timing is everything and often the Fed has moved too late. These are real concerns but we do not have to follow the usual playbook. The Fed is unlikely to hike to recession, and the corporate sector will begin to react as margins come under pressure.

Just to repeat again, we are not discussing the depth and length of any recession - which is the most important aspect to consider - just the dread “R” word. In addition, this time the Fed is managing employment expectations and has been clear there may be some fallout but is not going to precipitate an unemployment crisis.

1st quarter done, next up, 2nd quarter earnings

Earnings have been strong so far, with margins in both the US and Europe suggesting that companies have been able to pass on inflationary pressures. This is unlikely to continue into Q2 earnings, and it is likely that we begin to see some margin squeeze as the continued supply chain issues, and effects from the Ukraine conflict feed through to raw material prices. Consumer behaviour has already begun to change (see previous note) and added to that is an increasing inventory overhang as companies have ordered ahead. This will result in margin squeeze as ultimately prices will have to come down to work through the inventory as consumer demand eases in certain areas.


No real changes here. The tussle for ascendancy between inflation and slower growth concerns has seen the later rise at least in the short term, with Treasuries rallying. The 10 year is stuck at around 2.80%1 at the moment. We continue to keep our duration hedges on for now, and also have continued with credit hedges in Europe, given the more fragile economic environment in comparison to the US.


Nothing new. We continue to expect margins to come under increasing pressure, with second quarter earnings coming in weaker than expected. We still do not see recession this year, but do expect inflation to peak and begin to come down. As a result we continue to be cautious for the next few months but believe a lot of the negativity has been priced in, especially for duration sensitive bonds and higher quality.

[1] Source: Bloomberg, May 2022


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