Data – Turning south.
This week, market focus turned quickly on chances and depth of an economic slowdown. In Europe, June PMIs surprised on the downside, with readings now just above 50s, vs mid-50s just a month ago. Higher prices and supply restrictions are gradually affecting expectations, curbing new orders and consumer demand. Germany’s new gas plan may entail rationing and higher consumer prices, adding to the negative outlook. Finally, Fed officials sounded more worried about chances of a downturn, and US inflation expectations started moving lower for the first time over the past few months. According to our internal models, chances of a recession have increased recently, but are still well below what’s priced in markets. Based on current economic trend, we estimate chances of a US recession over the next two years at 60%, vs 95% implied by asset prices. Moreover, tailwinds from post-Covid re-opening mean that if a slowdown comes soon, it is likely to be more shallow than comparable historical episodes, with growth rates unlikely to fall into negative territory for long. We continue to find credit spreads wide vs the actual risks ahead and recognize selected cyclical equity markets now start looking interesting given more aggressive recession pricing.
Rates – Too much relax priced for 2023?
Rates markets tightened aggressively over the week, as investors focused on higher chances of a slowdown.10y Bunds and Treasuries are back respectively at 1.4% and 3.1%, 40bp off recent highs. Front-end rates followed the move. The US curve now prices a 3.2% terminal rate, vs 3.8% just one week ago, and cuts in 2023. European curves now price a much shallower hiking cycle than a week ago, with 1.9% terminal rate but less than 150bp in 2022. While central banks Are clearly more concerned about growth now, high levels of inflation make it difficult to fully backtrack from a hawkish attitude. Powell testimony in front of the Congress this week acknowledged higher economic risks but put inflation firmly as the priority. The ECB just turned more hawkish in June and will be hard to backtrack without hurting credibility. The bar in terms of economic weakness appears thus quite high for central banks to re-orient their priorities, and rates markets may put too many hopes in central bank support this week. EU inflation data on Wednesday will be an important market pivot and may help markets refocus on inflationary risks and hikes.
Algebris Investments’ Global Credit Team
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