Market Insights - July 18, 2022

The energy crisis and rising social tensions have weakened Italy’s economy, which in turn has sparked political turmoil. Now more than ever, the country will have to rely on NextGenerationEU funding. Mario Draghi has been overseeing the much-needed reform process, so his departure would not be good news.

At 0.4%, China’s GDP growth fell short of expectations in Q2, but economic data for June have been surprisingly upbeat. Retail sales grew by 3.1% year on year after declining 6.7% in May. Manufacturing output also rose. However, additional stimulus measures will be needed to keep this momentum up for the rest of the year.

The US bond market has held up well in the face of ever-rising US inflation (+9.1% year on year). Medium- to long-term inflation expectations suggest that the pace of price rises will soon start to ease.

USA – sidestepping a recession

Just six months ago, investors were singing the praises of the US’ robust economy – but today the word “recession” is on everyone’s lips. This growing uncertainty has been reflected in a steep decline in US stock markets since the start of the year. Will the country be able to avoid a sustained contraction in economic output, at a time when the US Federal Reserve is poised to tighten its monetary policy drastically in an effort to fend off stubborn inflation? It’s a crucial question. If the US economy – and, by consequence, the global economy – is able to sidestep a recession, the downtrend in stock markets we’ve seen over the past few months could soon come to an end. The magnitude of the current index correction and the length of this painful adjustment are consistent with the declines that tend to occur during economic downturns, but not recessions. Yet if US GDP growth turns negative, this bear market could get more severe and end up lasting much longer.

Of these two scenarios, we expect the more optimistic one, since a growing number of indicators are pointing to a normalisation of inflation rates. First of all, consumer demand looks set to ease. Persistent inflation has pushed up the cost of living for many households and dampened consumer confidence – all the latest surveys reveal that households plan to curb their spending in the coming months. Especially since, after the recent bout of frenetic buying, the excess savings built up during the pandemic have largely been spent. It’s hard to see how consumer goods can keep getting more expensive if demand starts to fall. This could prompt the Fed to adopt a more dovish tone and pull the brakes more slowly, thus preventing the US from tumbling into another recession. The recent drop-off in oil prices also suggests that inflation could start to normalise. We would also point out that, as a result of the stock market correction in the first half of this year, valuations are now much more in line with current financial conditions. P/E ratios have dropped from over 20 six months ago to 15 today, meaning the inflated prices seen at the start of the year have mostly readjusted. In light of the uncertainty, we are maintaining our neutral stance on the US market. We would like to see confirmation that consumer price growth has returned to a normal pace before we switch to a more constructive outlook.

Europe – the crucial issue of Russian gas supplies

Europe was already experiencing slowing growth and rising inflation at the start of the year, and the war in Ukraine has amplified both those trends. Owing to its dependence on Russian oil and gas, the region has been hit very hard by the war. Despite a nearly non-stop flow of bad news, however, purchasing managers’ indexes have not yet moved into contractionary territory. What’s more, consumer spending is also holding up better than expected, thanks to the excess savings built up since the pandemic broke out and to government measures aimed at boosting consumer spending.

In this environment, the about-turn by the European Central Bank (ECB) on inflation does not simplify matters. The ECB entered monetary tightening mode just as the economy began losing steam, and the central bank’s action is increasing the risk of recession in Europe. The ECB will have to introduce an anti-fragmentation mechanism to keep the spread between peripheral and German yields in check, so that interest rates can be raised without triggering a sovereign debt crisis. The biggest risk for Europe relates to its gas supply, and there is very little visibility on this situation. If Russia were to turn off the taps completely, European countries would quickly go into recession, starting with Germany and Italy, which are among the main importers. In our view, it is one of the few potential events that the financial markets have not yet priced in.