Inflation pressures continue to rise but risks of a stagflation growth shock are mitigated by stability in data and positive developments relating to COVID treatments
Global risk sentiment deteriorated last week as the market priced increased risks of a stagflationary environment. Markets were volatile, with moves exacerbated by month and quarter end flows.
Global equity markets fell; MSCI world had a 1.8 weekly stdev move lower and S&P500, European equities and the Nikkei all fell by more than 1 weekly stdev. In currencies, the US Dollar made yearly highs. The Euro fell by 1.8 weekly stdev reaching the lowest level since the US presidential election night in 2020 and the Mexican Peso underperformed in emerging markets. Emerging market interest rates continued to rise, led by sharp moves higher in Czech and Polish rates. European energy prices continued their parabolic rise, with 1mth LNG prices rising by 29% over the course of the week, 88% on the month.
September was a challenging month for risk assets. Indeed, on a volatility adjusted basis, it was the worst month for emerging market currency and fixed income assets since March 2020. Volatility rose this month from a low base driven by interest rate volatility and idiosyncratic stories such as Evergrande. The sharp move higher in US interest rates and the USD, pressured the EM credit complex which saw large selling on the back of ETF outflows.
While there were technical and idiosyncratic factors that worked in September to exacerbate price action, the market is pricing a growing risk of a slowing growth, high inflation environment into 4Q. The question is, is this warranted? There are two areas where there is little uncertainty.
1/ Inflation: Inflation, especially in emerging markets does continue to rise and is broadening.
In Latam rising energy and food prices, (exacerbated by Brazil experiencing a historic drought) continues to push headline inflation higher. In EMEA, German and Polish inflation rose again last week as rising energy prices add to existing inflationary pressures. Global input prices and supply chain friction remain high, and wages are going up in many developed economies. There is an energy “crisis” in Europe driven by extreme lows in natural gas inventories.
2/ Policy: Global liquidity conditions are tightening.
Emerging market central bankers are tightening policy in response to inflation, even as domestic demand has not fully recovered from COVID levels. Last week, the Czech central bank increased rates by 75bps, the largest rise in 20 years, and we saw rate hikes from Colombia and Mexico. The Federal Reserve is very likely to taper in Q4 and complete the process by mid-2022. The Bank of England may raise rates as early as December in response to rising wage inflation.
However, when it comes to the growth outlook, the picture is less certain.
Growth deteriorated over the summer driven by the Delta variant, ongoing supply chain friction and Chinese policy measures. September data does not show a sharp rebound in activity on a broad basis; PMI momentum has slowed in the Euro area and US real consumption has also slowed. There has been no policy response from China yet to any of the myriad challenges facing their economy.
However, manufacturing PMI data did stabilize, showing a modest improvement for the first time in 4 months and the US economic surprise index had the largest rise since June. Delta affected sectors in Asia are showing signs of recovery. Most importantly for the medium-term outlook for emerging market growth, 19 of the top 25 fastest vaccinating economies are now in emerging markets, and the Merck antiviral may reduce the need to take economically damaging measures to protect healthcare systems in the future.
Taken together this is an inflationary environment, and one where policy is being tightened. As we have highlighted previously, inflationary environments are more volatile in aggregate, as the market has to price policy reaction or policy mistake. Therefore, we are comfortable that as long as inflation continues to rise in EMEA, the market will continue to price higher risk premium in interest rate curves; which is why we remain paid Polish rates and have been short German bunds. Given the Federal Reserve are likely to tighten policy, we have run USD hedges and have had shorts in Treasuries, which we reduced this week following a large move higher in US interest rates.
However, the growth outlook remains uncertain. Indeed, from where the market narrative is currently and where some assets are priced, the asymmetry is to the upside with respect to global growth. This creates opportunities, especially where prices have been brought to levels close to valuation floors. In particular, we don’t think that September data justifies the deep sell off in emerging market credit. We have taken advantage of the selloff in September to buy Argentinian and Zambian USD bonds. These bonds should benefit from an easing in the global risk environment, while at current prices they have a very asymmetric return profile given expected recovery values.