Seatbelts On For No Landing

Upward growth revisions and a robust US labor market challenges the goldilocks soft landing narrative that had driven the rally in risk assets in January. The risk is skewed higher in terminal rates and if data continues to be strong then the Fed may be faced with having to hawkishly re-pivot or allow inflation to be higher for longer.

January was an exceptional month for risk assets. Euro Stoxx 50 rose by 9.75%, its best January in 30 years, and Nasdaq +10.62%, the best since 2001. Meanwhile, the USD had its worst January since 2011.

Underpinning this rally was the market pricing a “Goldilocks soft landing” scenario, where falling demand in key developed markets would generate enough disinflation to allow the Fed to cut rates in the second half of this year, while the China reopening and easing energy prices would spur economic activity enough to avoid a hard landing.

This viewpoint was supported by a clear shift in Fed communication and actions since November. Far from the somber tone we saw at Jackson Hole, Fed speakers have reacted to falling CPI with optimistic talk of a soft landing and the risks of overtightening. 

Data had also supported the thesis that a hard landing is not actualizing. As JPM has noted, “after reaching expansion lows in November, the global manufacturing and service-sector PMIs jumped in January, with constructive news on orders and inventories, along with a marked improvement in buiness expectations for growth this year.”

Last Wednesday, Powell added fuel to this narrative. He explicitly refrained from  pushing back on the divergence between the market pricing for 2023 rates (which showed ~50bps of *cuts*) and the Fed’s own dots from December. Furthermore, he did not push back against the easing in Financial Conditions in the last 6 weeks. He also mentioned “disinflation” 10 times in the press conference. It is not a stretch to say the tone of the press conference veered towards “mission accomplished”.

As one would expect, the market rallied and the USD sold off. Our first response was one of caution. This was creating, from our perspective, a very unstable equilibrium that could eventually catalyze an adverse asymmetric reaction in risk assets.

The strength in the US and global economy was at the center of our assessment heading into this year, supported by the easing in FCI, which was not consistent with the disinflationary trend we had seen in Q4.

In our view, if the US economy was stronger than the Fed assumed, then the Fed may need to re-pivot hawkishly, or, perhaps, they are comfortable with a higher level of inflation in aggregate. If data began to surprise to the upside, this would lead to a volatile repricing in markets, as the market had moved so much pricing into the soft, disinflationary landing.

While we saw the risks as distributed to the upside for US growth, we did not expect this view to be so clearly supported by January’s non farm payrolls data.

Put simply, this payroll report was extraordinarily strong relative to expectations and for this stage of the cycle. The headline job gains of 517k were 3x expectations, and it brought the unemployment rate down to 3.4%, a 50 year low. Average weekly hours rose 0.3 hours to 34.7 hours, resulting in total hours worked rising by 1.2%, an exceptionally strong reading. Revisions were positive, and the participation rate rose to 62.9%, a cycle high. To highlight, on an unadjusted basis, employment contracted by 2.5mm so the correct way of viewing this number is that the contraction in employment was less than any January back to the mid 90s. Also, average hourly earnings “only” rose by 0.3%, in line with expectations. However, what is clear is that the totality of the data does not show a significantly weakening labor market or imminent recession. Instead, the US labor market has remained remarkably resilient in the face of the tightening delivered so far.

While this NFP report is only one piece of data, the ISM Service report on Friday was also much stronger than expected and showed a re-acceleration in US service sector activity. There are many indicators that we watch closely, which also give us the conviction that risks in the US economy are skewed to the upside. First, most of the US data weakness in Q4 came from ‘soft’ survey-based measures of growth, with ‘hard’ data broadly holding up throughout the quarter, and now accelerating in the January data we have received so far. Our NLP approach to gauging consumer and business confidence and the prevailing economic narrative suggests the near-term risk for US animal spirits is to the upside - raising the likelihood that the ‘soft’ survey data we saw in Q4 starts to catch higher towards the (now improving) hard data.

Second, the daily credit card spending data we track on the US consumer shows a marked acceleration in spending in January - an improvement that suggests the risks are to the upside for January retail sales - especially in light of the acceleration in personal income implied by Friday’s NFP report and the January COLA increase for social security recipients. Finally, we believe the FCI easing that’s occurred since October is starting to reverse some of the tightening effects on US demand felt in 2022.

One area where we see this impact already is in the US housing data we follow, which suggests the US housing market supply is starting to tighten up, with house prices already stabilizing and home sales off their Q4 lows. Factoring in the right tail risk of a re-acceleration in commodity prices caused by China’s reopening and the still unresolved capex restraint in the energy sector raises the probability that the market and Powell have overestimated the disinflationary forces in the economy.

How the Fed and Powell react to this number (beginning on Tuesday) will be central to the path of assets in the near term. On balance, we think Powell is unlikely to shift course so soon after last Wednesday's press conference. However, if data continues to remain strong, there are only two options for the Fed

a) Hawkish Re-Pivot: Creating a policy driven hard landing: Higher terminal rates, sharp curve re-flattening, equities weaker, USD stronger.

b) Dovish Higher-for-longer: Resulting in no landing: Higher terminal rates, moderately stronger USD, higher inflation swaps

In both scenarios, we see upside to 2023 rates and one major theme playing out, that of divergence.

While the US economy is showing remarkable resilience to the level of high interest rates, other economies are either already experiencing harder landings like the UK, Sweden, and New Zealand or at a significant risk of entering one like Canada. These central banks will not be able to hold rates high for long or re-accelerate hikes, so these rates markets will increasingly diverge as they move forward through the year. This divergence is the key difference relative to last year, and we are still in the early stages of this trade.

Overall, the market is now aware of the risk we outlined to investors last week. However, we believe there is still a strong bias to support and further price Goldilocks: there are still 35 bp of rate cuts priced for this year, and equities are still close to the local highs. We may see a short-term relief rally if Powell does not shift his tone on Tuesday. However price action in the last 48 hours shows the low margin for error for this scenario, and the next CPI report will be pivotal.

Goldilocks Is A Fairytale

The soft landing scenario that the market is currently pricing is an unstable equilibrium that can be undermined by good data or a run of bad data. The more it is priced as a central case, the greater the asymmetry if it is invalidated and data over December and January will be central for shaping the outlook ahead.

If inflation was the key driver of the market regime over the last 12 months, it is increasingly clear that growth and central banks’ reaction function to weakening growth will drive the coming quarters.

Price action displays the market’s desire to trade a scenario of falling growth and falling inflation, with policy responses that will ease financial conditions in response.  Data which supports this scenario is eliciting a much stronger price response than data which does not. Part of this is the unwind of long held positions in USD and rates, but substantively a gradual deflating of G4 economies, policy support via cuts, coupled with a Q1/Q2 reopening of China is a soft landing and very different from zero-COIVD and an unbounded right tail of short term rates.

Last week’s price action displayed this market dynamic. Despite societal unrest and weak data, China proxies had a sharp rally as policy makers continued to gradually ease lockdown policy. CNH had a 3 stdev weekly move stronger vs the USD, HK shares rose by 2.5 weekly stdevs (+14%) and industrial base metals rose. In developed markets, Powell’s speech on Wednesday was not hawkish and, in some senses, dovish, however it lead to an outsized market reaction, including a 2.8 stdev daily move lower in short term US interest rates (1y1y rates fell by 35bps high low), the Nasdaq rising by 4% on the day and the USD falling by 2.3 stdev between Wednesday and Friday.

Finally, despite a very strong US employment report relative to expectations (263,000 jobs added, average hourly earnings 0.6% mom vs 0.3% expected) US rates finished the day lower than where they entered this data print.

These types of market moves are clearly impacted by the level of positioning that had been built over this year. In this context, we think there are two specific elements at play. Firstly, the duration and degree of trends resulted in large CTA positioning that, as anecdotal evidence suggests, is still being unwound. Secondly, the right tail of continued Fed hawkishness combined with rising inflation (and idiosyncratic risks) has likely resulted in large USD over hedges by real money accounts. The speed of the regime shift has meant that these positions still need to be unwound. Given the time of the year, these flows are having an outsized impact on markets.

The medium term outlook, however, is much more uncertain. Yes, there is growing evidence of a slowdown in global growth / global recession and peaking of inflation. Actions taken from Chinese policy makers do point to a shift away from zero-COVID. Powell and the Fed want to pause to allow the cumulative effect of tightening to take hold, but did not explicitly push back on the easing of financial conditions that have resulted from a dovish interpretation of this shift. Other central bankers have shifted more explicitly to an increased focus on growth, especially where property markets are contracting.

However, nominal inflation remains very high. The US labor market remains resilient despite some signs of slowing in the economy. There are limited signs of an offramp in the Ukraine war and a China reopening would add significant upside pressure to commodity prices into a tight market. Fed policy rates are likely to remain at or around 5% for at least another 6 months.

The path to the soft landing that is currently priced is via a fall in demand enough to bring down inflation, creating a shallow recession, enabling policy to be eased but without a significant labor market contraction or, in certain countries, a major property crash in the interim.

Right now that is where we are in the data but that scenario can be invalidated if either data is stronger than expected or weaker than expected and as such it is an unsustainable equilibrium for risk assets. This dynamic explains the driver of much of the recent market volatility.

Overall, from our perspective it is much too early for a soft (recession driven) landing to be a strong central case. Indeed, what characterized the inflation shock post COVID was a sequencing issue whereby extraordinary stimulus created a bullwhip effect in labor and goods supply. It seems plausible that the opposite could occur. In response to policy, rates have risen at the fastest rate in decades and the economy may contract much quicker than inflation can ease, pressuring policy makers to keep policy tight until a hard landing is unavoidable. Indeed a China reopening may support demand over time but in the short term exacerbate inflationary problems globally.

Therefore, the next few months' data will be key. The market is giving central bankers the benefit of the doubt that soft landings can be achieved, policy rates can be cut and the path forward is more positive for risk assets. This is certainly possible, but it is a narrow path that requires much more evidence to support it. The desire for the market to believe in this scenario, however, creates opportunities as the more it is priced as a central case, the greater the asymmetry in asset prices if it is invalidated.

Don't Get Caught Offside

A peak in US inflation is not a green light to go on offense. The reality is that the path to a soft landing is narrow and a hard landing is a clear risk. In the spirit of the World Cup, those playing for an extension of the recent bounce in risk assets may find themselves caught offside.

We wrote last week that a peak in US inflation and slow exit from zero COVID in China does not necessarily mean the start of a new risk on regime, and that “it is hard to get structurally bullish risk assets unless you have a high degree of confidence in a soft landing or a China reopening that is not met with even more policy tightening in DM”.

Last week's price action repriced higher the probability of the hard landing scenario , and lower the probability of a China reopening. Notably, northeast Asian and commodity exporting currencies underperformed, with the Korean Won, Chilean Peso and Chinese Yuan all having 1.5 - 2 weekly stdev moves lower. We also saw demand side inflation proxies moving lower, with oil falling by 1.4 weekly stdevs and 2y US inflation swaps falling by 1.2 weekly stdevs.  In contrast, US interest rates moved higher again, both on a nominal basis, and vs the rest of the world with AUD - US 5y rate spread widening by 22bps.

In our view, this retracement was warranted.

Put simply, the path to a soft landing is narrow. The full effects of policy tightening from developed markets have yet to be felt and indeed, have yet to be delivered. Secondly, while the direction of China's COVID policy is relaxing, China is experiencing one of its most severe COVID outbreaks of the pandemic, which is being met with severe restrictions. While the outlook for Chinese demand is more promising for 2023, as policy evolves away from zero COVID, in the near term, the chances of a Chinese white knight for global growth are slim. A reopening in China may be a more notable boon for Chinese domestic services demand than for the broader global economy, as long-term headwinds for property investment in China may mute the demand spillovers to the rest of the world that have been associated with Chinese investment-led demand expansions.

In contrast, there is growing evidence of hard landings ahead in Canada, Australia and Scandinavia - driven by the property market and in the UK, due to stagflationary conditions with no capacity to provide countercyclical fiscal support.

Focusing on the UK. last week's data makes for grim reading when assessing the possible depth and duration of the contraction ahead. CPI prices surprised to the upside, rising by 2%mom, bringing inflation to 11.1% y/y, the government announced a £55bn fiscal consolidation package, split almost evenly between spending restraint, notably less energy support and tax increases and next year, the Office for Budget Responsibility expects fiscal tightening to be ~1% of GDP. The UK labor market, however, remains strong, with near historical lows in unemployment and wage increases well above trend. Together, this means it is likely that the BOE will need to bring rates well into restrictive territory and will be hiking for quite a bit longer.

The dynamic in the UK displays the exact point we have made previously;  DM labor markets remain strong and any deterioration in growth so far has happened in spite of, not because of, a rise in unemployment. This creates significant asymmetry, if labor markets also begin to weaken, the harshness of the landing could be much more severe than currently priced.

Therefore, our prevailing outlook remains intact. A recession is likely, but the nature and depth of that recession are the key questions. The data over the coming months will shape the outlook for next year, and this level of uncertainty will likely mean navigating some choppy markets ahead.

The market wants to believe in a soft landing, but that probability should not be overpriced. It will likely take some time before the conditions are in place for a more structurally positive risk outlook. On the other side of the fence, risks of a hard landing are meaningful, but much more so in countries with a clearer link to weakening property markets (Canada, Australia) or suboptimal policy mixes (UK). In contrast, the US remains relatively resilient, allowing or requiring the Fed to maintain tighter policy for longer. In this environment rates divergence will continue to be a key theme, and the USD can outperform again especially if the hard landing scenario actualizes.

The End Is Not The Beginning

Easing inflation in the US and the slow exit from Covid signal an end to two of the key themes that have characterized 2022.  However, this does not necessarily mean the start of a new risk on regime, with the full effects of policy tightening delivered and still to come, yet to be felt.

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Market regime shifts or trend exhaustions are typically met with a rise in volatility as the market's distribution of outcomes moves from a one-sided distribution to one that is equally distributed or skewed in the opposite direction. The longer the trend, the more volatile the pullback as long held positions need to be cut and in some cases reversed.

This explains the significant moves we saw last week following weaker than expected US CPI and supported by further signs of China reopening.

The result was the USD, US rates and global equities had their largest single day moves since the COVID crisis and before that, the peak of the GFC. Trades that reflected the prior regime of rising US inflation, hawkish Fed and a weak China experienced a historical reversal, all moving by more than 3.5+ daily standard deviations resulting in US financial conditions having their second largest single day easing since 1990.

The specifics of the US CPI print were certainly encouraging. Headline CPI and core were both lower than CPI fixings and consensus economic estimates. While this level of inflation remains high relative to history, there are clear signs of a softening in inflation and a narrowing of the pockets of inflation pressures. Viewed in the context of other data points, there is growing evidence of a slowdown in the US economy, despite the labor market remaining resilient.

In China, evidence continues to grow of a policy shift away from its zero COVID policy. There were a range of new measures released this week after the Politburo Standing Committee meeting that, together, will ease the restrictions on domestic mobility and international travel.

Altogether the developments in the last 3 weeks from China, global policy makers and with global inflation, all signal that the regime of maximal policy tightening driven by rising inflation and a weak China is potentially towards the end of its life cycle. 

This, however, is not the same as saying we have shifted definitively to a singular new regime. Markets can move quickly, but the data and policy makers (especially in China) move slowly.

Uncertainty about the path forward remains very high. For example, a China reopening may reignite inflationary pressures globally. The Fed will be happy to have seen the first meaningful inflation miss, but discouraged by the level of financial conditions easing that followed, and, over the weekend, Gov. Waller was at pains to reiterate that they have a “ways to go” before pausing.

What this means is that the next few weeks and months of data points will be important for shaping the market backdrop as we head into the new year.

In our view, bearish exhaustion is high across markets and the market wants to believe in a soft landing of falling inflation combined with a shallow recession.

However, central banks remain hawkish (if less than previously) and, especially in the US, reactive. In the absence of a much harder landing, policy is likely to become more restrictive into the new year.

The job losses reported in tech, the collapse of FTX and implosion in crypto, alongside the weakness in housing, is the lagged effect of policy tightening and potentially the start of this hard landing. But, with unemployment remaining at cycle lows across DM, we are still in the early innings.

With this asymmetry, it is hard to get structurally bullish risk assets unless you have a high degree of confidence in a soft landing or a China reopening that is not met with even more policy tightening in DM.

Breaking Ranks

We have entered into a phase shift in global monetary policy. Central banks ex US are blinking, delivering dovish surprises even as inflation remains stubbornly high. This increases the probability of a regime shift to a much more divergent policy and market backdrop.

Last week saw significant volatility continue in global markets driven by increased divergence in policy and some signals of growth positive policy changes from China.  Asian equities lead global equities higher, rising by 2.5-3 weekly stdevs as hopes rose for an exit from China's zero covid policy. In conjunction with this, industrial base metals rallied, Iron Ore rising by 1.9 weekly stdevs. Hawkish commentary from the FOMC resulted in US yields rising by another 25bps over the week with the terminal rate for this cycle making new highs.

However the major macro theme we saw last week was continued divergence from developed market central banks.

October 2021 was the beginning of the end of the transitory inflation narrative, as global developed market central banks pivoted away from growth centric, maximally stimulative monetary policy stances.

A year later, we are seeing the opposite. Over the last number of weeks, there has been a clear shift in the global monetary policy reaction function. Notably, we have seen a number of dovish surprises (BOE, Norges) with the early movers of 2021 (Canada, Australia and Poland) having all delivered dovish surprises by slowing the pace of rate hikes. There are clear signs of a phase shifting the global policy backdrop.

For countries like Australia and Canada, there are good reasons for this shift. In both countries, the domestic housing market shows significant signs of weakness. Australian home prices declined for the ninth straight month in Sydney, and the national housing price index fell again by 1.2% in October. In Canada, there are clear risks of a housing market shock, with rising Non Performing Loans among property developers, falling prices, falling confidence and a sharp slowdown in activity.

Broadly, the global economy is slowing. In October, the global all-industry PMI fell to 49, which, as JP Morgan notes, is a record low outside of a recession. The slowdown is most pronounced in manufacturing, which has been hit by weakening demand at a time of sharply higher input costs.

The US is not immune to the impact of tighter financial conditions. This is especially true in the housing market, where real residential investment fell 26% SAAR in 3Q, on top of the 18% 2Q drop, and pending home sales fell by 10% in September.

However, this loss of momentum in the US still places the US economy in a far better place than the rest of the world. The US labor market remains remarkably resilient. While Friday's employment report was more mixed than prior reports, with noted weakness in the household survey and the slowest pace of job gains since 2020. However, unless we see a sudden stop, we are still some ways away (to borrow a phrase from Chair Powell) from the extreme tightness in US employment easing.

Hence, the Fed continues to signal a prolonged period of tight monetary policy. Chair Powell took great pains to state that a shift in the pace of hikes is not signaling a pause, but rather that the terminal rate will need to be higher than they had expected. He went on to say that the risk of doing too little outweighed overtightening. This ran almost directly contrary to the tone of the rest of the world’s central bankers over the last two weeks.

The challenge for policy makers is that inflation shows very few signs of easing. Global inflation surprised to the upside in October, with core inflation becoming an increasing driver of inflation readings.

Policy makers find themselves in an uncomfortable place.  However, what was revealed in October is that growth and financial stability risks are now back at the forefront of some policymakers' minds. This reaction function, developed over the course of the post GFC era, is supported by increased noise from politicians. The pendulum is swinging from one where central banks had significant political air cover to tighten policy to one where they have to justify focusing on inflation over growth.

Together, with some signs (although tentative and early) of a shift in China's zero Covid policy, risk assets have seen sharp rallies with Friday's 3.5x daily stdev rally in commodity currencies the largest since Covid. This rise in volatility across assets is consistent with the market on a cross asset basis, pricing regime shift.

However, the nature of what is to come, is less certain. While there are clear signs of bearish exhaustion across assets, the fact that inflation has not fallen yet does not support the idea of a shift to a benign liquidity environment in the near future. Further, if China reopens, this would likely add to the global inflation mix.

To us, the major theme that is building is one of divergence. For countries with worsening growth outlooks and rising financial stability risks, the asymmetry is for continued dovish surprises. If inflation shows signs of falling, we expect this to accelerate. If it doesn't, the persistence of negative real rates is likely to continue, and that will over time undermine currencies.

In contrast, the US is still a “ways off” from a meaningful pivot, which we believe will only come after a sharp contraction in economic activity and rising unemployment. We therefore expect the trend of widening spreads US vs ROW to continue to play out over the coming months especially vs Australia and Canada.

However, we would highlight one clear risk: If inflation does not fall, but growth continues to deteriorate, then a global stagflation scenario is here, and that is not likely to be a positive environment for risk assets.

Good News is Bad News

The US increasingly stands alone with a demand side inflation problem, tight labor market and a committed inflation fighting central bank. If CPI surprises to the upside the Fed will shift even more hawkish (in contrast with the dovish surprises we are beginning to see from the rest of the world) which may result in a volatile tightening in financial conditions via a much higher USD and lower equities

The start of the 4th quarter has seen no let up in the market volatility that has characterized the last 9 months. However, there were some notable developments that support our view that we are shifting into an environment of greater divergence.

Last week saw significant ranges in global rates and currencies. 10y US yields fell by 25bps (a 4 stdev daily move) last Monday, before ending the week 7bps higher in yield. Similarly, Dec 23 Euribors traded in a 60bp range over the week, and a volatile position unwind in the USD saw GBPUSD trade briefly on a 1.1500 handle before ending the week <1.11. Oil rose by ~10%, a 1.8 weekly stdev move, following the decision by OPEC+ to cut its production quota by 2mm b/d. Global equities traded in a volatile range, with Nasdaq ending Friday unchanged, having been up 6.3% on Wednesday.

The key data release of the week was the US employment report, which continued to show a tight and strong US labor market. Headline nonfarm employment increased by 263,000 last month. Close to expectations, the unemployment rate fell back to a cycle low of 3.5%, and average hourly earnings growth rose 0.3%, or 5.0% on a year-ago basis, and blue-collar wages were up 0.4%, for a 5.8% year-ago gain. This data is consistent with the low level of initial and continuing claims, and there is very little sign of any meaningful easing in the tight labor market conditions in the US.

Notably, despite limited signs of any easing in global inflation, we have seen three dovish central bank surprises in the last ten days. Overnight the Bank of Korea had two dissenters for a 50bp hike, decreasing the likelihood of a further 50bp hike in November. More interestingly The Royal Bank of Australia raised rates by 25bps, when there were ~44bps priced, and the National Bank of Poland held rates unchanged (33bps priced), despite last Friday's inflation reading showing a re-acceleration in CPI, bringing yoy CPI to 17.2%. It is worth remembering that Australia and Poland were the lead indicators last year for policy pivots hawkishly.

Tomorrow we will get the key US CPI reading for September. After August’s surprisingly strong reading the market expects a sequential fall to 0.4% from 0.6%  in mom core CPI. The key watchpoint will be whether the shelter component shows any signs of softening. A drop in inflation driven by goods (used cars) will have limited impact on the monetary policy stance of the Fed.

Overall the volatility over the last 14 days is indicative of a few key themes that we believe will drive the next quarter.

Despite the fall in financial assets, a cooling housing market, and 300bps of hikes so far from the Fed, the US labor market remains on very firm footing. Wage growth, trend hiring, and unemployment rate are all historically strong. The inflationary impulse from the labor market has not yet responded meaningfully to tightening financial conditions, and is indicative of broad strength in the outlook for US demand. The fact that US inflation is clearly demand driven means the Fed will tighten until they see clear signs of these measures falling. This narrative can be changed with a weak CPI but on the other hand, if CPI does not show signs of easing the Fed is likely to become even more hawkish in the near future.

In simple terms, the evidence so far suggests that we have not yet found a level of rates that is enough to significantly slow the demand side of the economy. This, however, is a different dynamic than when the Fed is starting its hiking cycle. Now we are at the “price discovery stage” - ie. How far do rates need to go until data turns? This brings in a more two-sided distribution for rates. Negative data surprises will lead to some easing in financial conditions, but strong data (especially employment and inflation) should extend the duration and peak of the hiking cycle. This is the reason for the extreme volatility priced for tomorrow's CPI  with the market pricing a move of 2.5% in S&P 500 – the second highest implied move since 2010 (only after March 2020, 3%).

However, in our view, the fact that the US labor market remains so robust means that the likelihood of a meaningful Fed pivot in the near term is low. This means that the risk remains skewed higher for nominal rates, with the market still pricing an effective end to the hiking cycle by Q1 2023. For long duration assets like equities, this means the likelihood of a truly risk supportive Fed is slim. Indeed, a real income shock from higher oil prices may be one way to accelerate a recessionary slowdown, but this is unlikely to be broadly risk supportive.

In contrast, the rest of the world is increasingly facing a much less straightforward policy decision set. In Europe, the energy supply shock means policy makers cannot control a key aspect of the inflation shock, while the economy suffers to a greater extent. Poland has blinked, clearly signaling that the central bank is unwilling to bear a level of growth destruction. In Australia, the impact of a weaker China and the downside risks to the housing market pushed the RBA to adopt a slower approach. Similarly, in the UK, the risks to the domestic housing market from the currently priced rates are severe, limiting the BoE's ability to over deliver and indeed maintain a very hawkish policy stance.

This is a world that is looking increasingly divergent. At one pole are the US and the Fed, while on the other are the countries facing real stagflation and growth shocks. This divergence, alongside the impact of data prints as we move later in the cycle, means greater volatility, but it is also a strong environment for currency trades and relative rates trades. However, if US Inflation shows further signs of firming, this divergence is likely to manifest in a very strong USD rally and a sharp selloff in equities. The good news of a strong US economy is ultimately bad news for risk asset holders and the rest of the world. 

Great Britain Pounded

The challenging global macro backdrop is testing policy makers to the extremes. Some like the BOJ prefer to ignore external realities and maintain accommodative monetary policy while the UK is erring on the side of reckless fiscal policy expansion. Both are highs stakes gambles that in times of inflation will most likely not end in a soft landing.

It has been an extraordinarily volatile 5 day period in global markets, with some of the largest moves in rates and FX markets outside of peak crisis periods (GFC, EZ debt crisis, Covid). This volatility reflects (a) a shift in the markets understanding of how long and how restrictive policy will need to be to control inflation and (b) an understanding that politics may exacerbate the risks presented by this environment.

There were three main developments that worked together in concert last week.

1.       Monetary policy actions

This week, there was a clear theme from the Fed, SNB and BOE. Each central bank under delivered relative to expectations for this meeting, but signaled a higher for longer approach to the rate hiking cycle. This shift away from front loading means the peak of the rate hiking cycle is further away, and increases the probability of rates remaining restrictive for longer. The net result is an increase in term premium globally. This is risk negative and also signals that the hiking cycle is earlier in its life cycle than previously thought.

2.           Geopolitical developments

President Putin announced a partial mobilization of reservists and conscripts to fight the war in Ukraine under the guise of secession referendums in Russian held provinces in Ukraine. He also signaled a willingness to use tactical nuclear weapons. This meaningful escalation increases the risk of a prolonged war in Ukraine, as well as a significant military escalation on the part of Russia. This in turn increases the risk of further reductions of energy exports, sanctions, and a humanitarian crisis in Europe should the war re-escalate beyond the front lines. The net result is a heightened probability of additional stagflationary impulse for Europe via lower growth (confidence) and rising energy costs alongside higher tail risks.

3.           Major UK Policy Shift

The new Conservative government announced a historic policy shift today in the UK. Previously the party of fiscal prudence, the new chancellor announced the largest tax cuts (focused on income tax and housing) since 1972, alongside the fiscal package to cap energy prices. This is, in effect, a massive unfunded stimulus package at a time when inflation in the UK is >10% and the 1Q current account deficit was -8%. The likely impact is to push the UK fiscal deficit to 6-8%. Twin deficits to this degree are among the worst of any developed or developing economies in the last 20 years.

This was a major surprise. The government had kept the tax cuts secret to achieve maximum political benefit, with the result that the BOE's policy decision looked wildly out of sync yesterday. The effect is that UK fiscal policy is now maximally stimulative, while the country faces an inflation shock, with the government fiscalizing the energy inflation shock while reducing its domestic tax base.

The moves since the mini budget in UK fixed income have been extraordinary; UK 2y swaps have risen by 95bps in two trading sessions, and the GBP has had a 10% range on Monday alone.

This type of volatility is consistent with a crisis, and is reasonable given the macro vulnerabilities of the UK. The BOE will likely need to raise rates much more than they expected, bringing UK policy into restrictive territory. With that, the risk of a destructive recession has increased further. However, the political response to a recession “created” by the Bank of England is highly uncertain. Risk premia in UK assets will likely remain elevated for some time to come.

The overall result of last week's policy moves has been a volatile increase in global term premium, alongside heightened stagflationary risks in Europe. Market volatility is indicative of a regime shift, and that is appropriate. Higher for longer means global liquidity conditions will remain restrictive until after the effects on inflation are tangible. This is de facto, the exact opposite of the inflation targeting policy that the Fed brought in in 2020. 

This shift is significantly risk negative, negative for equities and negative for currencies with negative real yields, and / or dovish policy. It means the YCC policy in Japan is inappropriate for the environment. Reports suggest the MoF in Japan sold $20bn to intervene last week, and USDJPY is within 1% of the level they intervened at.  In simplistic terms, if 1y risk free USD rates are 4.5%, why allocate anywhere else until the prevailing risk environment improves?

For countries facing a stagflationary shock, the outlook is worse. The UK has shown that there is a limit to how much the market will tolerate pro growth policies at a time of high inflation. For the ECB, failure to deliver the 180 bps of hikes in the next 3 meetings will place additional downside pressure on the Euro, but over delivery will likely push Italian bond yields above 5%. There are countries who can fiscalize this growth shock, but that is not every country in the Eurozone, and the great weakness of the Euro (no fiscal transfers) is again raising its head.

While effective policy responses from the BoE and the ECB may reduce near-term spikes in risk premia, the structural issues facing the global economy, and in particular Europe are not easily fixable. The market is becoming aware of these issues, but as the UK showed this week, there is much more room to run if confidence in policy makers is tested.

Inflation Fighting Favours The Brave

Inflation pressures are not easing and the Fed faces a key credibility challenge as we head into the last 3 meeting of 2022. Over deliver in this meeting or risk losing control of the wheel.

It was an eventful week in global markets following the significant beat in US core CPI, which showed continued broadening of inflation. This upended the “soft landing” narrative (of easing inflation pressures with a resilient economy) and instead provided clear evidence that the level of demand in the US economy is continuing to generate significant inflation and further tightening will be required.

The consequence was a large selloff in global interest rates (specifically the level of rates priced for the middle of 2023, with June ‘23 Eurodollars and Euribors implied yields +2.6 and +2.3 weekly standard deviation moves higher), and, a sharp fall in equities (Nasdaq down ~7% from pre-CPI levels with the largest single day fall since Mar 2020), broad strength in the USD (+2.5 weekly stdev rally from pre-CPI to Friday) and a widening in credit. Rates curves also flattened between 2023 and 2025 tenors with the spread between March 2023 and December 2025 rates seeing a 2.8 weekly stdev flattening on Wednesday.

Across assets, price action reflected the market increasing the probability of the scenario we outlined in our note at the end of August.

“The risk for equities is that Powell is approaching the point where actions will need to follow words. Current market pricing indicates the Fed as having largely finished its hiking cycle by December (13bps priced for Q1) with a final 25bp hike in Dec[ember].

Time is running out. If inflation is not falling, Powell will need to open up the probability of either larger rate hikes to Dec or hikes into 2023. This would undermine definitively that we are approaching the end of the cycle which has been a key premise of broad equity market support. Further, it will drive upside in yields well above 4.00%, which will seriously undermine long duration equities. In turn we would expect the 2023-2025 curve to flatten by 75-100bps in this scenario and equities to come under significant pressure…

The longer the equity market holds on to a belief of a soft landing and a non-hawkish Fed, the greater the pain if that reality doesn't play out. A 3.5% selloff in equity markets on hawkish comments is illustrative of this asymmetry, but it is only the opening act if the Fed needs to follow tough talk with tough action.”

Our view has been that the market has consistently overpriced the probability of a soft landing by overweighting the probability of a fall in core inflation (despite the continued strength in shelter and the labor market) and underweighting the commitment of the Fed to bring inflation down. Furthermore the “soft landing” narrative was particularly vulnerable to either leg being disproven. The inflation leg is what happened in part last week. The Fed leg may still come.

However, even with the recent selloff, the scenario of persistently high inflation and a credible Fed continues to be underpriced. There are only 3 meetings to the end of the year, and the pricing for those are 79 bps, 70 bps and 43 bps. This means that there is only 33 bps of additional upside in yields vs forwards if the Fed is capped at a maximum of a 75bps per meeting. In addition, rates pricing for the start of 2023 still shows less than 1 x 25bp hike in the first two meetings next year.

This is the challenge facing the Fed and the source of significant asymmetry in risk assets. If the Fed wants to overdeliver hawkishly vs what is priced, that means either 100bp hike in September or October or some new, clear communication that increases rate hike pricing into 2023. “Hope” is not a monetary policy strategy, and it seems clear that the rate hikes so far have done little to halt the inflation that is being generated within the economy. Therefore, the necessity for hawkish overdelivery remains.

From our perspective, a 100bp hike is warranted and consistent with recent Fed communication and is what is required to re-establish credibility. Indeed, given market pricing, equities may rally if the Fed delivers 75bps. The EM playbook is clear, a central bank who is serious about fighting inflation should tilt in favor of hawkish overdelivery rather than run the risk of any perception of dovishness. Inflation fighting favors the brave.

However, the more likely outcome is that Powell adopts a hawkish tone, with hawkish September forecasts alongside a 75bp hike, which only pushes the asymmetry a little further out on the curve. If inflation continues to be elevated in October’s data then 100bps will be back on the table and eventually we believe the pricing in H1 2023 will be challenged.

We believe this is the most underpriced scenario in markets. Without strong action from the Fed to tighten financial conditions, it is growing increasingly unlikely that we will see the type of cooling in core inflation that would allow the Fed to pause in December. In a case where hikes continue into 2023 then we expect there is 50-75bps of upside in yields in the first half of 2023, which will continue to support the USD, flatten the curve between 2023-2025 tenors and serve to undermine long duration equities such as tech stocks. If they do increase rates by 100bps on Wednesday (which they could), that repricing happens sooner and in a more volatile fashion.

Either way, the Fed faces a key challenge this week. Take the opportunity for a hawkish surprise by moving 100bps or run the risk of waiting when the cost benefits may be much worse (see our note below). The base case is more of the same, and a continuation of a data dependent market and Fed, but we view the risk of a true hawkish surprise on Wednesday as material.

US Inflation Update:

Tuesday’s August CPI report was yet another beat, with Core CPI beating expectations with a +57 bps m/m increase. The beat was broad-based, with strong increases in shelter, medical care services, personal care, and autos. Core goods accelerated to 46bps m/m, despite decelerations in PPI and import prices indices facing businesses, suggesting businesses were able to continue to push their pricing onto end consumers. On the services side, core services rose by +58 bps, led by sizable gains in the labor market-sensitive shelter and medical care services components. While energy prices continued to fall in the August report with a -5.02% m/m decline, the strength in price gains outside energy in the report suggests US demand remains high enough to validate the inflationary price-setting behavior (whether anticipatory or to 'catch-up' for lagged real income losses) that has become pervasive in recent months.

The breadth of the August report strength pushed m/m Median CPI inflation to a new series high in August. As the chart below comparing the annualized 3ma growth in Median CPI and the Atlanta Fed’s wage tracker illustrates, the US continues to face the most broad-based wage & price pressure since Volcker.

A key driver of Tuesday’s inflation surprise was a further acceleration in OER to 0.71% m/m - a new cycle and multi-decade high. As the left-hand chart below illustrates, the recent strength in shelter inflation has helped take the torch from other Core components to lead inflation higher in recent months. While some commentators have pointed to the cooling in for-sale US house prices and a deceleration in the growth of ‘spot’ asking rents, we are skeptical that rental inflation will fall much below it’s current 6.3% YOY rate in the next couple of years without a material weakening in wage growth and the unemployment rate.

First, while the pace of acceleration in ‘spot’ asking rents has indeed slowed - we believe the CPI indices are still a long way from fully reflecting the rental market repricing that has occurred over the last few years. This can be illustrated in the middle chart below, which shows the acceleration/deceleration of Corelogic’s Single-Family rental price index YOY (advanced 12 months) relative to OER YOY  The lead/lags typically seen with the Corelogic data suggest OER is on pace to keep accelerating well into the middle of next year. Additionally, the final chart to the right shows, an average of Zillow and ApartmentList rental prices over the last three years have increased at a ~7% CAGR compared to just +4.1% for the lagging and more smoothed CPI rental indices.

Second, we also see today’s slowdown in house prices as less predictive of a rental slowdown in this cycle than in the GFC cycle. While house price declines in the GFC cycle did lead rental deflation - that cycle’s house price declines were driven more by a mortgage credit availability shock, an imbalance between household formations and housing completions (completions > household formations) even before the labor market deterioration, and a flood of distressed rental supply from foreclosures associated with risky mortgage structures (foreclosures became rental supply).

In contrast, today’s slowdown in house price growth is related to a mortgage affordability shock that is pricing prospective new homebuyers out of the competing for-sale market (for-sale housing is a ‘substitute good’ to the rental market), the US is underbuilding relative to household formations and has been for over a decade (this is unlikely to change without a weak labor market), and there is limited distressed mortgage supply due to changes mortgage structuring/underwriting post-GFC and stronger homeowner balance sheets. In this cycle, with underbuilding relative to household formations and strong homeowner balance sheets, the mortgage affordability shock may even tighten rental markets further by raising the barriers for rental market participants to make the transition to homeowners.

Tuesday’s inflation report at 0.57% m/m Core and Thursday's 213,000 initial claims report should be clarifying about where the balance of risks lies for the Fed - even with FCI and monetary tightening shocks, gas price deflation, US dollar strength, and a domestic and international growth slowdown, the US economy remains imbalanced with strong inflationary inertia and aggressive price-setting behavior permeating the US economy. While lagging shelter pressures contributed to Tuesday’s beat, we believe shelter inflation will remain a major contributor to US inflation over the next year, with a slowdown to pre-pandemic rent growth norms in the next 18 months likely requiring meaningful weakening in labor markets.

Devastatingly Committed

Powell talked tough, but equities still hope for a dovish Fed. With few rate hikes priced past December there is still room for tough action to be priced and that is a significant risk for risky assets heading into the fall

Chair Powell’s speech last week at Jackson hole was brief by design. However, even if you only read these two sentences, you would have understood Powell’s key message: “Restoring price stability will likely require maintaining a restrictive stance for some time. The historical record cautions strongly against prematurely loosening policy.”

Powell’s comments communicated to the market that the Fed is committed to bringing inflation under control, despite the actions required and consequences of doing so. As Powell bluntly stated “Our responsibility to deliver price stability is unconditional” and doing so will “bring some pain”. The secondary message was that “we must keep at it until the job is done” giving further support for the higher-for-longer message that we had heard from other Fed speakers.

This was a hawkish message with very little equivocation. Clearly, the Fed does not see their job nearing completion and right now they view the risks of embedded inflation as outweighing growth concerns. Indeed, it will require a period of weaker growth to achieve their inflation aims.

However, from our perspective, there was very little substantively new in what Powell said (one could say that the major innovation seems to have been the brevity and clarity of the message!). We had been surprised how quickly the market narrative had shifted to “soft landing” and a balanced Fed in June and July. We did not see any such shift, rather our view was that the market had misinterpreted the dovish implications of the phase shift from “expeditious policy moves” to a more data dependent stance. Indeed, the data that matters (employment, wages and CPI), all continued to show significant inflationary pressures.  With this backdrop, we believed the idea that the Fed would dovishly pause in this scenario to be spurious. To us, the moves in equities on Friday were surprising, only insofar that equities had so far resolutely ignored any hawkish statements from the Fed.

At its essence, the problem that Powell faces is that the equity market, in particular, doesn’t fully believe that the Fed could actually be hawkish in the traditional sense. Equity investors have good reasons for holding this view. The market forced the Powell pivot in 2018 and since the GFC there has been a Fed put. Indeed, at the moment of peak inflation concern and equity weakness in June, there was a perceived Fed pivot which precipitated a 21% rally in the Nasdaq.

The fact that the equity market has responded to any equivocation or dovishness much more strongly than hawkish comments necessitated an unmistakably hawkish, stripped down speech. But even with that speech equity markets are still 10-15% higher than the June lows.

The risk for equities is that Powell is approaching the point where actions will need to follow words. Current market pricing indicates the Fed as having largely finished its hiking cycle by December (13bps priced for Q1) with a final 25bp hike in Dec. Time is running out. If inflation is not falling, Powell will need to open up the probability of either larger rate hikes to Dec or hikes into 2023. This would undermine definitively that we are approaching the end of the cycle which has been a key premise of broad equity market support. Further, it will drive upside in yields well above 4.00%, which will seriously undermine long duration equities. In turn we would expect the 2023-2025 curve to flatten by 75-100bps in this scenario and equities to come under significant pressure.

At the end of the day, the Fed has chipped away at its own credibility, but also it has served as a bulwark to equity market weakness for a decade. Words can only go so far; if inflation doesn't fall and FCI doesn't tighten significantly this credibility will need to be won back. The longer the equity market holds on to a belief of a soft landing and a non-hawkish Fed, the greater the pain if that reality doesn't play out. A 3.5% selloff in equity markets on hawkish comments is illustrative of this asymmetry, but it is only the opening act if the Fed needs to follow tough talk with tough action.

Finally a brief word on Europe following last week’s note. There are two key elements of the challenge facing Europe a) the European inflation crisis is a supply side shock and b) the unique structural weaknesses of the Eurozone. This means the European trade has a sequential element to it, with each policy action simply passing the risk to another part of the asset universe.

We saw this dynamic play out this week. In response to a weakening EUR and rising inflation pressures, we received leaks that a 75bp hike is on the table in the next ECB meeting. This helped support EUR, but resulted in a 2.8 stdev selloff in the March 23 Euribors, a 2.3 stdev curve flattening in 2023 / 25 pricing, peripheral and credit spread widening. Today, European inflation again surprised again to the upside driven by Italian inflation reaching 9%. Even with fiscal policy and energy price caps, there really are no good choices for European policy makers and there is a growing risk that policy makers never fully address any of the key issues. This would result in a correlated selloff in European assets, with equities, credit and fx all weakening, and is a meaningful tail risk in the outlook.

Hot Summer, Cold Winter

Europe faces increasingly severe stagflationary risks due to its energy crisis and markets are going to test the credibility of the regions central banks. Brace for a stress test in European assets.

It has been a hot summer for risk assets, but the outlook ahead is considerably bleaker, especially in the broader Europe, which is facing the risk of an acute stagflationary shock this winter.

The prolonged conflict in Russia-Ukraine, alongside an extreme drought this summer has pushed electricity costs sharply higher and we believe these costs are likely to remain elevated through the winter, generating a new inflationary impulse and causing a meaningful drag on growth. Real incomes and real interest rates are both firmly negative, political uncertainty is high and the risk of a test of central bank credibility in Europe and the UK is rising.

In our framework, a principal component of an inflationary environment is higher baseline volatility as the market prices a wider distribution of central bank driven policy outcomes . The further behind the curve, the more this risk premium builds as policy makers eventually pivot. Initially, the convexity is heavily skewed toward higher rates and then, as the cycle matures, volatility remains high but the distribution becomes more two sided.

A typical cycle (at least for the last 30 years) assumes that inflation is a demand side issue. While you can get rolling positive demand shocks (Trump tax cuts are one example), this is rare and so the likelihood of new inflationary impulses driven by demand is low and so inflation risk premium should fall over time.

This is not the case for supply shocks, as we are currently experiencing, as supply shocks can compound Furthermore, central bank policy is less effective to deal with supply shocks. In essence, supply shocks open up a whole different distribution of inflation risk premium and with that rates and curve shape.

This is a growing risk now in Europe as we head into the winter. The prolonged grinding war in Ukraine has given no room for any diplomatic resolution and countries are rapidly trying to rebuild gas inventory for the winter. Electricity costs are up between 50-70% in the last month across the curve and worryingly long term power costs (1y ahead) have also increased exponentially. This has been compounded by low water supply in the Rhine and elsewhere.

German Wholesale Power EUR/MWH - 1 year fwd

The impact on CPI will be immediate, with JP Morgan estimating an 83% surge in natural gas prices to consumers this October in the UK, which should hold the CPI above 10% through to the spring. For broader Europe, energy and electricity prices at these levels, alongside low water levels, present clear downside risks to manufacturing over the winter (we have already seen high intensity smelting plants shut). This assumes a normal winter, a cold winter would create conditions for a true energy and societal crisis.

There are signs that the prolonged inflation shock in Europe and the UK is feeding through into wages, with increases in negotiated pay (unionized pay) broadening across the continent. However, even with these wage increases, real wages continue to fall.

The 3.6 standard deviation move higher in UK rates last week is evidence of this dynamic and  this situation is not unique to the UK. From our perspective, the risk that the market tests the resolution of central banks in September is rising, with both the BoE and ECB looking significantly behind the curve again relative to inflation. In this scenario, we would expect meaningful new lows in EUR and GBP in a volatile fashion, which would push central banks to respond creating 30-50bps upside in front end rates, which we expect would flatten the curve by another 20-40bps in 2s10s.

Course Corrections

The global policy backdrop continues to become more hawkish as Central Banks attempt to grapple with the scale of the global inflation shock. However, their policy toolkit remains similar to that of the lowflation era, creating volatility and risk premium for further policy shifts.

As we wrote last week, "[recent developments have] laid bare the growing crisis now faced by the ECB and the Fed. There is a real risk that the current policy making tool kit and parameters are fundamentally unsuited to the inflation challenges they are now facing”.

The loss of central bank credibility is the true tail risk for global markets, and the increase in this risk was a) priced into markets and b) responded to by key central banks, all within a week. This created extraordinary volatility across key DM rates and FX markets.

What happened?

FOMC: The Fed’s forward guidance of two 50bp hikes was clearly inappropriate, given both the June inflation print and University of Michigan inflation expectation reading showed a “shocking” re-acceleration of CPI.

In response,having previously signaled 50bps right up until the end of the blackout period, the Fed delivered a 75 bps. This was a policy move without recent parallel, the fact that this hike was communicated via an article during the blackout period pre-meeting is a self-admission of the failure of their own policy stance and created significant volatility in US and global rates markets.

Inexplicably, at Wednesday’s FOMC, Chair Powell signaled a 50 or 75 bps hike at the next meeting, again reducing his policy options. It seems highly likely that this attempt at forward guidance will be challenged again if inflation in July remains elevated or accelerates further. We see the distribution of the next hike more likely between a 75 or 100 bps rather than a 50 or 75 bps hike . Indeed forward guidance, of any description in this environment, has consistently failed, resulting in pivots and asymmetric moves in rates markets.

However, policy communication aside, the clear interpretation of the FOMC decision, statement and dot plots was that the Fed are now unreservedly hawkish. They see themselves bringing policy into restrictive territory, and with it generating higher unemployment and lower growth. For equity markets, the Fed put is significantly “out of the money”, and implicitly an earnings recession will come alongside the cooling of growth desired by the Fed. 

ECB: Lagarde’s press conference at June’s ECB meeting was a failure in central bank communication. The lack of clear explanation of the monetary policy path and the plan to prevent a widening of peripheral spreads saw a dislocated move in European front end rates and spreads. This resulted in an unscheduled “emergency” ECB meeting on Wednesday, a mere 5 days after their most recent meeting. Here they announced they would apply flexibility in reinvesting redemptions coming due in the Pandemic Emergency Purchase Programme (PEPP) portfolio and mandate the creation of a new anti-fragmentation policy tool. This is likely to be announced at the next meeting, which, based on reporting, will likly include flexibility in purchases between countries with no ex-ante limit on purchases.

If the reallocation of PEPP reinvestments is sufficient, there are near-term implications  including, in a relative sense, upward pressure on core yields and downward pressure on peripheral yields. If effective, this will allow for a more aggressive monetary policy path, which will, over time, flatten European yield curves. Outside of the PEPP announcement, this week's moves highlight the unique relative weakness of the ECB to other central banks.
Therefore, there should be a higher level of risk premium in European rates curves and in the EUR, as the main shock absorber should policy risk increase again or the anti-fragmentation tools prove to be insufficient. Once again European financial market integration and the need for a debt/fiscal union has not been implemented adequately to withstand a renewed Eurozone debt crisis. Hence, in this highly inflationary environment where energy inflation has yet to fully feed through into HICP readings, we see a severe test of sovereign spreads and a debt crisis as the path of least resistance.

Switzerland: The SNB shifted hawkish, unexpectedly raising rates 50 bps with hawkish guidance on rates and the currency. Furthermore, they opened the possibility of foreign asset sales. Given the size of the SNB’s holdings of global bonds and equities, SNB quantitative tightening is a meaningful hawkish development for global liquidity conditions.

Japan: The BOJ’s commitment to their yield curve control (YCC) target was tested, with yields implied by futures trading through the target level in the first half of the week. However, the BOJ reaffirmed (and doubled down) its commitment to its extreme dovish policy, and the JPY ended the week back towards the lows. YCC is “unsustainable” only insofar as the Bank of Japan deems the trade offs of maintaining the policy undesirable. For now, weakness in the JPY has not reached that threshold, and furthermore had they changed policy, the volatility created by this shift may have caused a wide vol/var shock given the prevailing market backdrop. While the BOJ stubbornly upholds its overly stimulated YCC levels we see the Yen as a weak link alongside JGBs.

Normally, volatility of the kind we saw last week is indicative of a regime shift or exogenous crisis. This was not the case last week. Rather we saw market participants and central banks recognizing the magnitude of the inflation crisis. The policy outlook continues to be pushed to more and more hawkish footing by the breadth of the inflation crisis, but central banks still remain somewhat adherent to a policy toolkit from a lowflation era.

This policy stance will continue to raise the risk of convex moves in rates markets and increase the size of the ultimate policy adjustment. The outlook for growth is negative and while in more rate sensitive parts of the economy like housing there are clear signs of weakening, on the whole the economy continues to generate excessive demand. Therefore policy needs to deliver more tightening and with that DM interest rate curves are likely to invert and / or flatten further. This is a volatile, risk negative environment and one where rate paths will continue to be priced higher as long as inflation does not ease.  We see the combined impact on global equities as a clear negative, notwithstanding the possibility for short lived relief rallies.
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Global Property Markets - At the Epicenter of Policy Shifts

One of the key drivers of sharp post-COVID demand recoveries in the US and several other DMs has been the robust expansion in the housing sector. In the US, this housing sector expansion has been fueled by:

·        A structural underbuilding in the US housing market

·        Strong nominal household income growth

·        Positive demand shock from the rise in remote work

·        Historically attractive for-sale mortgage affordability relative to rents

·        Expansionary monetary policy.

With the sharp tightening in mortgage rates from 3% to over 6% since the beginning of the year, the last two of these drivers have quickly reversed to headwinds. The combination of the rapid house price increases of the last year and rising rates have pushed mortgage payments for the marginal homebuyer up by a remarkable ~64 YOY, a historic deterioration in affordability that has only been matched in the Volcker shock.

The mortgage rate tightening is not just a headwind for first-time homebuyers – it will also depress refinancing activity and liquidity for existing homeowners.

On the refinance side, mortgage analytics firm Black Knight estimates that the pool of refinance candidates in the US who would benefit from refinancing at lower rates has fallen to just 472,000 households (from ~15 million households last summer).

With the post-GFC regulatory environment constraining HELOC and second lien borrowing options for many homeowners relative to pre-GFC norms, these higher mortgage rates will undermine refinancing activity in the US – effectively trapping much of recent housing market wealth gains in a less accessible form for homeowners.

With most US homeowners holding long-term fixed-rate mortgages, higher mortgage rates will also lock some homeowners into their existing mortgages (and homes) due to an inability to qualify for a new higher-rate mortgage on a second home - this likely will help hasten the decline in housing activity. In the near term, we expect the scale of the affordability shock to sharply dampen housing transaction activity, house price growth, housing market confidence, and refinance activity in the US.

The US’s housing boom, which has been an important reason to be constructive on US growth in recent years, can no longer be counted on to support US growth in the near-term. However, we do not have as a base case a sizable national US housing price reversal in nominal terms or household deleveraging cycle in the US as better underwriting, positive equity positions with fixed-rate long-term debt structures that are affordable relative to rental equivalents (for existing owners), lower household debt ratios, structural US underbuilding since the GFC, and higher inflation should help buffer nominal US house prices.

We see more significant housing-related growth risks in a few DMs facing much more challenging mortgage affordability dynamics than the US – namely Canada, New Zealand, and Australia. As the chart below shows, mortgage affordability pressures are now much more acute in Canada than in the US for marginal homebuyers. In addition to more challenging affordability dynamics, these countries also have higher levels of household leverage, shorter-term and more interest-rate-sensitive mortgage structures, larger household balance sheet exposures to housing wealth, and larger residential investment shares as a percentage of GDP.

Brace For Impact

If central banks really do what it takes to address the inflation crisis then the left tail for equities and the right tail for rates are both opened up significantly, and in a way that we have not experienced for several decades.

The global inflation crisis has worsened and reaccelerated. Global May CPI (ex. Turkey) is tracking a 0.7% m/m gain, the second-highest monthly increase on record, and, per JP Morgan, global CPI will rise at ~10% yoy this quarter.

Last week's developments in data and markets have laid bare the growing crisis now faced by the ECB and the Fed. There is a real risk that the current policy making tool kit and parameters are fundamentally unsuited to the inflation challenges they are now facing

In the US, the Fed faces trade-offs not seen since the 1970s and 80s.In Europe, the trade-off between an inflation shock in a context of heterogeneous sovereign credit risks is unprecedented in the life of the Eurozone.

These trade-offs have been reflected in the global asset market price action through extreme moves wider in European sovereign spreads and a sharp sell off in European equities and a acute, correlated selloff in fixed income and equities in the US. Indeed in the US, the only other instance in the last 40 years where over a 2 day period, 2y rates moved higher by more than 50bps and equities lower by more than 5% was October 14 1987 which preceded the Black Monday crash of October 17 1987.

So what happened?

1. Europe: At a headline level, last week’s ECB meeting was a significant hawkish pivot, delivered primarily through its statement and staff projections, which saw significant increases to near-term inflation forecasts and downgrades to growth. Implicit in these staff projections is that policy is likely to be restrictive on a go forward basis. The intent was to open up a more front loaded hiking cycle, including the strong possibility of a 50bp increase in September.

However, this hawkish pivot was not given a substantive explanation by ECB President Lagarde. Furthermore, Lagarde offered no specifics as to which tools they would or could use to prevent “fragmentation” or sovereign spread widening in a case of an aggressive hiking cycle.

This lack of certainty about what the policy stance compounded the effect of the hawkish statement and forecasts. Risk premium in European front end rates increased, and no guidance on anti-fragmentation tools saw spreads widening sharply. For spreads, the ECB has no consensus as to what their plan would be in the case of a major increase in sovereign spreads, at the same time as inflation requires an aggressive hiking cycle. At worst, there is no more ECB backstop outside of a major crisis.

2. US Inflation: The US inflation print was shocking to the market, politicians, ex policy makers and, implicitly based on recent statements, the Fed.

The headline CPI index rose by 1.0% in May, raising the yoy rate to 8.6% (its highest since 1981). The core index increased 0.6% last month, with broad based increases in the stickiest part of the inflation basket, alongside shelter increasing to a cycle high of 0.6%, with rents showing the highest reading in several decades.

There was no silver lining in this reading. Energy and food prices are set to stay elevated or worsen, the sharp fall in housing affordability and lack of supply will continue to pressure rents higher, the labor market remains tight. Heading into the second half of this year, US inflation has broadened and accelerated, and this is being reflected in long-term inflation expectations, with the Univeristy of Michigan median five-year-ahead measure rising from 3.0% to 3.3%.

Implications - A much wider left tail

The bottom line is that the hawkish shifts by policymakers have, so far, been woefully inadequate to address the scale of the inflation shock. In chronological order, the problem was ignored, misdiagnosed, under estimated, and is now being managed conservatively.  For example, the last inflation print in Europe was 8.2%, wages are increasing sharply, their own staff forecasts show a sharp increase in inflation, and the ECB’s own policy guidance is to continue to have negative interest rates heading into September!

The Fed has made a similar mistake, pre-committing to 2 x 50bp hikes, and some governors even discussing a potential pause while the data would subsequently show inflation was in fact accelerating.

It is clear that current policy is inappropriate for the inflation challenges currently being faced.

Recent data does not support the scenario of a gradual easing of inflation pressures (a soft landing) through easing supply chain bottlenecks and the impact of broadly tighter financial conditions. Much like we saw with Poland, waiting for a deus ex machina solution to inflation only exacerbates the ultimate policy tightening necessary.

What data does support is that we have passed the point where inflation can be addressed in the US and Europe without a major demand contraction. If that point has been passed, the longer policy makers wait, the worse the problem becomes, and the more painful the re-adjustment.

In the case of Europe, the implications for sovereign spreads add to this tail, and we have not tested whether a monetary union without fiscal union can survive a true inflation shock. The trade offs are clearly grim.

Fannie Mae 30y Mortgage Rates – 6.13.22 is the 4th largest single day increase in 20 years

Therefore, the central question shifts to whether policy makers will actually follow through on the monetary policy required to address inflation. This means an exit from any semblance of gradualism and a toolkit much closer to an orthodox EM central bank.

This would be a category shift for the market. Looking at the the equity sell-off in May, interest rates fell and resultantly financial conditions eased. This is precisely the opposite of what is needed. If central banks really do what it takes then the left tail for equities and the right tail for rates are both opened up significantly and in a way that we have not experienced for several decades.

10y US Swap rates: Blue / S&P 500: Red – In May equities and rates moved together providing a shock absorber for long duration assets. This is not the case in June.

This week, the Fed will be instructive, with full updates of dot plots and projections. There is now a 50% probability of a 75bp hike in July, but this seems light in the context of the inflation outlook. To quote Jason Furman, Obama’s chair of the NEC and noted center-left economist, “This is a "whatever it takes" moment for the Fed. They don't need to raise faster in June. But they need to be crystal clear that they will raise rates to 4, 5, 6, etc. if needed”.

Q2 - Inflation Fighting

The last quarter was a regime shift to a world where economic growth is no longer at the center of monetary policy and central to international relations. This shift has been catalyzed by inflation and the invasion of Ukraine and it will shape the macro and geopolitical outlook for the foreseeable future.

The events of the first quarter of 2022 will have historical consequences, as well as shaping the near-term political and macro backdrop. The confluence of a historical inflation shock, central bank policy shifts, and a tragic war in Europe led to levels of market volatility that are only seen in the most stressed market environments.

As we head into the 2nd quarter, the market is pricing in 245bps of hikes for 2022 in the US, up 180bps from the start of this year with 50bp hikes now the modal estimate for the May, June and July meetings.

Oil is above $100bbl up 30% ytd, German inflation is at 7.3%, the highest level since reunification, and Sberbank market cap has fallen from EUR86bn on January 1 to EUR225m following unprecedented weaponization of sanctions in response to Russia's invasion of Ukraine.

German 5y Yields Blue / Germany YOY CPI Red

The magnitude of these moves reflects a market regime shift, or more technically, the market repricing the distribution of asset price returns in a non-linear fashion. Specifically, there were two significant regime shifts in the first quarter:

A) A shift by the Fed (and with that other DM central banks) that the inflation backdrop would require a much sooner and sharper rate hiking path. Like the scene in Jaws, central bankers are realizing that “we are going to need a bigger cycle”.

B) The invasion of Ukraine, which resulted in
(i) weaponization of sanctions in an unprecedented fashion
(ii) the largest shift in European defense policy in 60 years
(iii) a structural shift in European energy policy
(iv) the end of Russia as a high-quality investible region for the foreseeable future. In the space of a few days, Russia went from an emerged economy to frontier status with irrevocable damage from an ESG perspective.
(v) a possibly long lasting shock to food supply chains which will have a exorbitant effect on low income developing economies with social unrest, political turmoil and fiscal risks as a consequence (this is already happening in Egypt, Sri Lanka and Peru).

The downstream impacts of what has happened in Q1 are numerous and have already resulted in major asset price movements. However, there is one clear consistency: in both the shift in monetary policy and the policy response to Russia, growth was superseded as a policy priority. Politically, there is strong public support for the sanctions packages, and fighting inflation is the number 1 issue for voters ahead of the US midterms. In effect, the global policy backdrop, political environment, and public sentiment have shifted hawkish.

With this as the macro-political backdrop, there are many market implications. The bottom line is that the longer inflation is allowed to continue, the more severe the policy measures will be necessitated, and with that the greater the risk of significant growth or equity market correction.

1.       Persistent inflation = Higher rates

The US inflation problem is not easing, it is broadening. Per Goldman Sachs, their comprehensive labor force measure shows the US labor force at the most overheated level in the postwar period, both in absolute terms and relative to the population. 2y real interest rates moved nearly 100bps less negative from the lows in March, but they are still -100bps and 100bps below pre COVID levels, and 200bps below levels seen in 2018. Indeed, US financial conditions eased throughout March, driven by an exceptional rally in US equities, and remain meaningfully easier than any period pre-COVID. This is a big problem for the Fed, even after the historic increase in nominal interest rates this quarter, financial conditions have barely tightened relative to historical averages. If inflation and inflation risk premium do not fall, rates will need to be much higher to tighten financial conditions to the level necessary to get control of inflation.

US 2y Real Interest Rates - Still well below recent and historical averages

2.       The downside risks to equities continue to grow

The corollary to this point is that further equity market increases are unwelcome, as they signal to the Fed that prevailing financial market conditions remain too easy. As we wrote in 31JAN “this Fed wants to be long optionality, not short a policy put to the market. The dominant variable that will determine the Fed policy pathway is not the stability of equity markets, it is the path of inflation over the next 3 quarter”.  Not only is the Fed put gone, but equity market rallies also increase the chance of even more aggressive policy tightening.

3.       European rates will remain high with upside skew

While the European economy has meaningful structural differences to the US, 2y European real interest rates are -390bps vs the 5y pre Covid average of -140bps. A lot has been priced in quickly into the European interest rate curve, but real rates are more, not less negative due to the increase in inflation risk premium. This type of monetary policy stance will become politically untenable, especially for the northern European economies. The risk remains skewed to the upside in European rates, with fiscalization of inflation placing increased pressure on fiscal balances. Indeed, with pressure growing for more aggressive sanctions on Russia, the risk to the inflation outlook in Europe is tilted to the upside, even as German policy makers in particular try to push back against more sanctions targeting Russian gas.

4.       Trading the cycle means EM can continue to rally

As we noted in our note 11 Reasons Why Emerging Markets Will Roar in the Year of the Tiger, tightening global financial conditions, commodity market strength and high nominal interest rates, is an environment which can support certain EMs. This played out in 1Q it is a theme that will work well in a world where growth begins to be priced down in DM and curves continue to invert. This is the powerful effect of the fact that EM moved ahead of DM in their tightening cycles last year and are now in position to capitalize as the outlook for asset returns in DM deteriorates on a real and nominal basis.

In sum, despite the moves in global rates markets and the substantive shift in policy, the central macro issue of inflation has not eased, it has worsened. The level of policy tightening that may be necessary may, still, be much greater than what is currently priced, and the hawkish shift in policy, politics and geopolitics means the tolerance level for a meaningful hit to growth and equity markets is high. The longer inflation is allowed to rise, the harder it will be to affect the level of tightening without a meaningful growth or equity market correction, and that risk means terminal growth rates will be priced lower, which can help continue to support higher yielding EMs. Structurally, this is not a time to be short volatility or convexity, it is an inflationary environment, only one that has had fuel added to its fire.

COVID Update

World COVID cases fell last week, with cases falling in Asia, Europe, CEEMEA, Latin America, and the US. However, unlike the improving COVID environment for most of the world, China’s outbreak continued to rise, with daily cases on Sunday hitting a record 13,146. In Shanghai, most of the city’s ~25 million people are under strict stay-at-home orders, with recent reports suggesting the outbreak in the city has been getting worse. As the chart below shows, China’s Omicron wave is unlike anything the country has seen since March 2020 and is the first real test of the country’s zero-COVID policy approach against the significantly more infectious Omicron variant.

Calvion’s View: We continue to see significant risks from China’s current COVID outbreak. The current combination of elevated cases, the more infectious Omicron variant, and continued adherence to strict zero-COVID policies creates additional near-term risks to Chinese growth and global supply chains. However, COVID risks look limited outside of China, with the potential for continued recoveries in COVID impacted service sectors over the course of the year.

• “Economic and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts and figures are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Information herein has not been reviewed or approved by either a Fund’s auditor or administrator and is subject to change. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Consult your financial professional before making any investment decision.”
  

Red Alert In Macroland

Despite heightened uncertainty, our central case of an inflationary macro environment that has experienced an additional inflationary shock remains. In effect this is the same market backdrop as pre the Ukraine-Russia war, only accentuated.

Three weeks after the invasion of Ukraine, global markets continue to be extraordinarily volatile. European bank stocks have rallied back 25% in 10 trading sessions, US front end rates have risen by 85bps having fallen by 45bps in risk-off dip in early March and this week Chinese internet stocks rose by 45% in 3 trading sessions, having fallen by 33% since the start of March.

This level of market volatility is similar to the COVID-19 crisis, and like that period, the impact of non-market variables (fiscal policy shifts, geopolitical risk et al) is significant. However, unlike COVID, there is not one shared global shock, but rather many factors working together to create exceptional macro uncertainty, and as this uncertainty rises and falls, the market experiences significant shifts in risk premium and large moves in asset prices.

This week there were three key drivers all of which are major themes by themselves.

1.           Russia - Ukraine war

Our central case is that economically speaking, the war between Russia and Ukraine is primarily a European centric stagflationary shock. The depth of the growth shock will be driven by the duration and severity of the conflict, the level of energy and commodity price rises, as well as whether there is further escalation in terms of sanctions. This growth shock (and part of the inflation shock) can be mitigated by fiscal policy response, and it is notable that the low in European stocks occurred alongside headlines of the potential for a large EU fiscal response to the crisis. The tail outcomes of a broader military escalation work to increase the depth of the growth shock and peak of inflation risks.

Over the last two weeks, the market has priced an increased probability of a negotiated solution, and the risks of a near-term military escalation have fallen, with the US and other NATO allies being extremely cautious to walk the fine line between the aggressive military aid given to the Ukraine and steps that could lead to a direct military conflict (Fighter jets and no-fly zones). Furthermore, as noted above, fiscal policy response is potentially on the table, and sanctions on energy exports from Russia have not yet reached the most economically adverse scenario. Therefore, it is reasonable that risks to growth and inflation have fallen from the acute levels priced at the start of this month.

However, we would caution that the developments militarily have, if anything, increased some tail risks. The significant casualties experienced by Russia are being interpreted as creating a need for a negotiated solution. However, these losses have also led to a shift in tactics towards indiscriminate bombing of cities (Maripol, Kharkiv) which creates a much higher human cost, and with that, the risk that current NATO policy becomes politically untenable. Similarly, we are concerned that the use of WMDs is not inconsistent with this strategy, especially as Russian troop losses mount. The Ukrainian position, supported by weapon supplies from the West, is increasingly entrenched, and while there have been concessions on NATO membership, there has yet to be any concession on territorial integrity.

The bottom line is that the situation in Ukraine is likely to get worse before it gets better. The prospects for diplomacy have improved, but while the war remains kinetic and Russia continues to escalate, the risks in the tail remain which is why we retain hedges in FX (Short Euro and Polish Zloty) and European Credit.

Our subjective probability distribution is below

Scenario 1: Russia regime change

Probability: 5%

Trades: none currently

Scenario 2: De-Escalation / Peace deal

Probability: 40% (30% limited sanction relief, 10% significant sanction relief)

Trades: long EU financials, long KZT, paid real rates as inflation risk premium falls, paid the belly of EU rates

Scenario 3: Military escalation and sustained conflict

Probability: 40%

Trades: long commodities (oil and wheat), short EGP and commodity importers, paid front end US rates, paid Polish rates

Scenario 4: Military escalation beyond Ukraine

Probability: 15%

Trades: short Euro via options, short Polish Zloty, paid EUR ITRX CDS

2.           The FOMC

The FOMC raised rates by 25bps as widely expected and released a hawkish set of forecasts in their Statement of Economic Projections. Specifically, the median dot for 2022 showed seven 25bp hikes, but nearly half the committee saw more than that number, implying a sizeable number of committee members who see the need for 50bp increments. Indeed, both Waller and Bullard stated as much on Thursday and Friday. Taken together with 3.5 hikes in 2023, the FOMC clearly signaled they want to bring policy into restrictive territory in the next 12 months.

Chair Powell in his press conference did not double down on the already hawkish message in the statement and dot plot, especially around 50bp increments. The equity market rallied and 5y real yields ended the week unchanged, having been 25bps tighter immediately following the FOMC statement and SEP release. While there were other factors at play to support the equity market, we would not point to the Fed as one of them. Clearly, this Fed sees the need to tighten policy, and they continue to rapidly change their policy stance to reflect a shift in their view of the tradeoff between inflation and growth, as evidenced by a restrictive forecast for the policy rate. The Fed remains significantly behind the curve, but they are catching up and the risk is skewed to higher rates, 50bp increments and a more aggressive balance sheet run down. We have reflected this in our book with shorts in Dec 22 Eurodollars, put spreads in Jun 23 Eurodollars alongside a paid 5y real rate position.

3.           A new policy put from China

The developments from China this week are significant. In sum, our view is that the intervention of the State Council’s Financial Stability and Development Committee (FSDC), chaired by Vice Premier Liu He, was directly aimed at re-establishing a policy put for Chinese risk assets. Specifically, the council signaled increased macroeconomic policy support, support for the property market, more cautious, transparent, and incremental regulatory actions for China's internet platforms, and that policy steps would be taken to prevent delisting of Chinese ADRs.

This powerful intervention saw the largest ever single day rally in HKTech, which had a 7 daily standard deviation rally on Thursday, however from a macroeconomic and growth perspective, it is the delivered policy response that matters. Indeed, the risks to China's growth have deteriorated in recent weeks, as the Omicron variant has seen renewed lockdowns and a fall in mobility, and so the bar has been raised if policy makers want to turn the tide. Certainly, a shift to a more aggressive stimulus stance and an improved outlook for Chinese equities would certainly be a significant positive impulse for global growth and EM assets, but even the fact that there is a policy put in place does improve the skew of returns for Chinese assets. We have initiated a position in long Chinese equities, but are waiting for policy delivery to add to this position

Overall, uncertainty about the medium-term macro-outlook is very high, however our central case of a high inflation, high volatility environment has remained despite the geopolitical and policy events in the last number of weeks. We consider the war in Ukraine to be an accelerant to this broad inflation theme and our portfolio remains paid rates and long commodities. We consider the tail risk of a military escalation as adding convexity to this position, but it does open up a downside risk to growth which is why we retain hedges in FX and Credit. Our assessment in Q1 that the risks of war were real paid dividends with our Ruble options expiring well in the money, here again we are not discounting the risks of a scenario that nobody wishes to see but that may indeed occur.

Not Quiet on The Eastern Front

The risks of a military conflict between Russia and Ukraine have risen materially. Any conflict is likely to be a volatility shock for markets but will only add to the inflationary regime that we are in.

Geopolitical risks dominated global asset markets last week, as rising tensions between Russia and Ukraine undermined global risk sentiment. We will focus on this in this week’s market strategy; what our current assessment is and what implications are likely if the situation deteriorates further.

Current Assessment

Our base case, since the Russian troop buildup began in Q4 2021, has been that this is most likely an exercise in coercive diplomacy. Therefore, while the pathway may be volatile, a diplomatic resolution was the base case. However, earlier in the year, we initiated tail hedges in Rubles, as we assessed that the market underpriced the probability of a military outcome. Over the course of the last ten days, there have been several developments which indicate that this risk has risen materially. The Sunday night announcement of an agreement in principle for a summit between Biden,Putin and Macron reduces the immediate risks if confirmed, but this is not a structural solution, and tensions remain extremely elevated.

There are several factors which inform this view.

1. Public statements from the US and NATO

These statements clearly indicate that the national security establishment believe that military conflict is the base case. Notably, President Biden stated on Friday in a public address that he has reason to believe that President Putin has given the order to invade. Public reporting from the Washington Post and NY Times indicates this was based on intercepted Russian orders to proceed with a full-scale attack. This reflects the level of Russian military buildup surrounding Ukraine, which has now grown to 150,000-190,000 troops, accounting for 75% of all Russian strike battalion groups.

2. Increased military activity in Eastern Ukraine

- The OSCE Special Monitoring to Ukraine (SMM) said it had observed a “dramatic increase in kinetic activity along the contact line in eastern Ukraine" over the weekend. Specific events in the last 72 hours included the “bombing” of a separatist leader’s car, the shelling of a Ukrainian kindergarten, “sabotage” of a major fuel line, Ukrainian shells landing in the Ros region in Russia, full mobilization in the separatist regions and evacuation of civilians to Russia. While the idea that Ukraine is the aggressor does not seem credible, these actions are similar to what was seen prior to the Russia-Georgia war in 2008, and intelligence analysts assess that these are consistent with the creation of a pretext for a Russian military incursion into Eastern Ukraine.

3. Lack of any diplomatic progress

Despite intensive communication, there has been no diplomatic progress. Russian demands for no further NATO expansion and withdrawal of troops from eastern Europe are unacceptable to the US and NATO, and Ukraine maintaining sovereignty over its foreign policy, which includes the ability to join NATO, are seemingly unacceptable to Russia. The rise in tensions and increased troop buildup have resulted in these positions becoming more entrenched, as evidenced by the speech delivered by President Zelensky at the Munich security conference and public comments to the UN by Russia and the US last week.

4. Russian media shift in communication

There has been a notable shift in the domestic media in Russia. This signpost is one we have been tracking closely, and in contrast with earlier in the year where Russian media had downplayed the risks of military conflict, Russian state media has now shifted to openly discussing military action into Ukraine in support of separatists.

From a market perspective, the uncertainty about whether a military conflict will take place, and the nature of such a conflict will continue to cast a shadow over broader risk assets. We continue to believe that a full-scale invasion and occupation is a tail risk, but any military conflict would likely be a near-term volatility shock, which negatively impacts European and Eurasian assets. Further, the market would price in some risk of an energy shock, which would increase near term stagflationary risks.

Viewed through a wider lens, a Ukrainian-Russian military conflict is unlikely to be a regime shift for the global macro backdrop, but it may add to the preexisting inflationary pressures in the global economy. To that end, flight to quality lead rallies in global fixed income may present opportunities to faded, while any easing in tensions will offer attractive entry points in Russian and Ukrainian assets. In the context of this uncertainty, we have added to RUB hedges and reduced headline equity risk but will re-add to these positions should tensions ease this week. More broadly our view remains that we are in an inflationary environment in which differences in where countries are in their monetary policy cycle create several opportunities for both directional and relative value expressions.

It's a Bird, It's a Plane, It's Supercore Inflation

Interest rate and bond markets are caught between pricing more aggressive inflation fighting measures by central banks and a flight to “safe” assets as geopolitical risks rise regarding Russia and Ukraine. However, with inflation likely to remain high and possibly accelerate further in a conflict, bond markets won’t offer safety they have in past risk-off episodes.

It was another volatile week in global markets, driven by extreme moves in rates in DM and EM, and renewed concerns about the risk of a Russian military action against Ukraine. Consistent with what we have seen recently, the largest moves were at the front end, with multi standard deviation moves higher in US, Colombian, Chilean, Mexican, Hungarian and Czech rates. Inflation surprises and hawkish policy developments were again the drivers.

The most important macro development was Thursday’s US CPI print and subsequent comments from FOMC members, most Notably St. Louis Fed Chairman James Bullard. This CPI print was a shocking number and possibly catalyzed a well overdue awakening from the Fed.

Specifically, headline and core indexes rose 0.6%m/m last month, pushing yoy headline inflation to 7.5% in January, the highest level since 1982 and core inflation to 6%. Tenants’ rent increased 0.54% last month, the fastest monthly gain since 1992, and reopening proxies such as airfares and dining away from home were firm. The broadening of inflation is seen in the Cleveland Fed’s trimmed mean measure (which removes outliers) rising by 5.4%oya last month, faster than at any point in the last thirty years. Viewed in the context of accelerating wage inflation, this is evidence consistent with an economy which is dangerously hot.

Unsurprisingly, front end rates moved higher following this print, however comments from Bullard added fuel to this rate selloff. He stated he was in favor of a 50bp hike and that an emergency intra meeting hike should be considered. Front end rates ended the day 25-35bps higher, and 2y rates had their largest intraday rise since the 1970s.

This price action reflects the growing risk that the Fed is much further behind the curve than was thought. Instead of easing, inflation is broadening to the stickier parts of the basket and accelerating, even as base effects should be placing downward pressure on headline inflation.

This data shows that the current policy stance is even more accommodative than we thought. The Fed is still buying bonds, and if we get another inflation surprise next month, the starting point for their hiking cycle could be inflation close to 8% yoy, with Unemployment at 4%.

US CPI Less Food / Energy / Shelter (Red) vs Fed Target (Blue)

The key point is that the Fed targets a level of inflation. By the time they hike, they will have allowed the economy to overheat for several quarters too long, and the probability of getting bailed out by easing supply chain pressures or base effects is being reduced by the incoming data. From this starting point, the type of hiking cycle required to get inflation close to the Fed target may be substantively different than we have seen before. This is what Bullard brought to the table – “this type of inflation is a regime shift from anything we have seen in the last 20 years, and therefore applying old frameworks may be inappropriate”.

More broadly, this week continues to show that the convexity in rates markets is to the upside as long as inflation remains high and does not signal a sharp turn around in supercore components. Quite simply, central bankers and street forecasts are consistently underestimating the inflationary pressures in an over-stimulated post-COVID world. Combining increased data dependency with heightened forecast uncertainty means the distribution of outcomes for global rate markets is very wide, and this means greater volatility. The addition of meaningful geopolitical risk and a potential energy shock only adds to this.

Several developments last week indicated to us that the risk of a military conflict between Russia and Ukraine had increased. Specifically, the military buildup had broadened to include significant naval assets in the black sea alongside forward deployment of rotary wing aircraft to the southeast border of Ukraine, both new developments. Further, diplomatic attempts had achieved no real progress with Putin’s press conference following his meeting with Macron marking a new departure in tone. Similarly, more worrying to us, the discussion on Russian local media has shifted somewhat. The news on Friday that the US had told allies that an invasion was planned for this week, and more importantly, that this information has been acted upon through the removal of both diplomatic and military personnel is consistent with a view that the risk of a military action has shifted meaningfully. The next few days will be crucial, with Chancellor Scholz visiting Kyiv and Moscow over the coming days. A key signpost for us will be whether Ukrainian and EU communication shifts, both have downplayed the risk relative to the US but ultimately the decision to invade rests with Putin.

Therefore, our portfolio continues to be balanced, with rates payers in the US, Europe and Poland and largely beta neutral equity exposure which is exposed to rising rate environments and our EM credit risk is low. We managed to exit our Russia equity positions profitably last week ahead of Friday's news due to increased local and international political noise mid-week. We will consider re-entering these equities lower as fundamentally they are excessively undervalued in  but we need to see tangible political progress and we expect for now things are likely to get worse before we see this. We continue to own puts and put spreads on the Ruble in addition to FX shorts in CE3.  With inflation prints in CE3, the Fed minutes, several ECB members speaking and the acute tensions in Eurasia, it is likely to be another volatile week ahead and our trading stance and portfolio remains tactical and opportunistic as we navigate this unique macro environment.

COVID Pandemic

World COVID cases continued to decline last week, with cases falling in Asia, Europe, and America last week and rising slightly in CEEMEA. In China, cases remained low last week, although they did rise. In India, cases continue to decline after the recent peak in their Omicron wave. In CEEMEA, cases continued to rise last week, although much of the increase was driven by record cases in Russia, and several CEE countries like Poland and Turkey have seen recent waves peak. In LatAm, except for Chile, most countries have seen the peak in Omicron waves, with cases broadly trending lower across the region.

Cases are falling in both the US and Europe, with the US Omicron wave leading Europe on its descent. Within Europe, the countries that first saw Omicron waves have led the descent in European cases. In the US, positivity rates continue to fall, and the leading data we track on wastewater COVID concentrations and Google Trends continues to point towards further declines in US cases.

Due to the combination of falling cases and changing perceptions about COVID risks, the share of Americans concerned with local COVID outbreaks (per the Civiq’s survey) is also falling sharply. These declines in COVID concerns and a likely further easing of concerns in the near term should support a renewed recovery in service sector activity.

Calvion’s View: We continue to be optimistic about the prospects for further recovery in activity in impacted services sectors, as COVID moves towards an endemic phase and COVID concerns fall further. However, some risk remains around policy responses, particularly in China, due to the country's zero-tolerance policy response.

11 Reasons Why Emerging Markets Will Roar in the Year of the Tiger

Despite a tightening policy shift from the Fed and ECB, the two most significant DM central banks,  and a broad tightening of financial conditions to start off the year, EM assets are outperforming. We see this strength as fundamentally warranted and a reflection of the compelling macro setup in EM asset markets. For the reasons highlighted below, we expect further outperformance of EM assets over the course of 2022. We would note that these highlighted trends are in reference to the broader EM complex, in particular EMs ex-North Asia, with important differentiation by country and region. 

Growth and Inflation:

1. We expect strong absolute levels of global growth to continue as global business capex and residential investment upswings continue, inventory drawdowns are rebuilt, and service sectors make a further recovery as COVID headwinds dissipate. 

2. On a relative basis, the fiscal tightening impulse in the US should help shift relative growth rates in favor of EMs, where comparatively tight-fisted finance ministers generally indulged in considerably less COVID-related fiscal easing than US policymakers. 

3. Inter-DM fiscal policy divergences also support EMFX, with the more appropriately staggered EU Recovery Fund support in Europe (in contrast to the US’s fiscal hangover) keeping relative growth dynamics in favor of the EUR in 2022. 

4. China’s recent policy easing and the trough in the Chinese credit impulse is also lining up to support EM growth in 2022, with positive implications for commodity-exporting EMs. EM rallies have followed every other Chinese easing cycle.

Source JDI Research

5. In this cycle, commodity-exporting EMs are additionally supported by a number of trends including nearly a decade of commodity-sector underinvestment, strong DM goods demand, and a global green transition which are helping to keep commodity prices well-bid. These divergent forces have already started supporting EM growth which has been surprising to the upside, in contrast to the relative weakness recently seen in US data.The below chart indicates that the Citi EM Economic Surprise Index (white line) is positively surprising, in contrast to the Citi US Economic Surprise Index (blue line), which is currently in negative territory.  While many EMs have been impacted by the same inflationary forces that were prevalent globally in 2021, we see scope for inflation in certain EMs to favorably diverge from global trends in 2022.

6. The fight against inflation, i.e. tightening of financial conditions has already occurred in some EMs. Many of the EMs with elevated inflationary pressure did not take the Fed and ECB’s ‘transitory’ line and have already been tightening throughout much of 2021 (e.g. Brazil, Russia, and the Czech Republic), often with hikes that have brought policy rates to levels in line with an orthodox Taylor Rule approach. The ‘long and variable lags’ of these 2021 monetary tightening decisions are likely to weigh on EM inflation relative to DM economies, where policymakers are only just now beginning their tightening pivot from levels that are historically diverged from the past rule-based approaches.

7. Output gaps and labor markets across most of the EM complex have more slack than in DM markets and EM economies are unlikely to be able to sustain elevated pricing power in labor markets and domestic service sectors. As base effects from global goods inflation peak in the coming quarters, we believe EM inflation will be characterized by the lagged impact of 2021’s monetary tightening and the relatively softer core services inflation dynamics created by negative output gaps and labor market softness. In contrast, in DMs like the US, while fading goods CPI base-effects will likely bring some reprieve to headline inflation figures in 2022, the late monetary policy response, underlying heat in core services (particularly rents) and wage growth strength could present a comparatively more challenging inflationary dynamic.

8. Relative to prior Fed tightening cycles, the capital inflow and balance of payments backdrop for EMs today is comparatively favorable. As Figure 3 from DB shows below, EM current accounts in most regions are better positioned today than at the start of the last four tightening cycles. In addition to the current account strength, most EM balance sheets in this cycle have sufficient reserve levels and foreign liabilities that are primarily FDI or denominated in local currencies.

9. A related bullish factor for EMs is the lack of foreign inflows over the last two years, resulting in near trough foreign positionings in many EMs and across EM asset classes. The light positioning is illustrated in the below charts from DB, MS, and BofA. In EM equities, global fund managers are near record UW EM equities relative to their benchmarks (per MS), while a January 2022 BofA Global Fund Manager Survey found a nearly -1 st deviation underweight relative to historical norms.

Per the below charts, a similar set-up can be seen in local currency bond markets (particularly for EM ex-China), where non-resident holdings as a share of outstanding bonds are approaching decade lows.

10. EM current accounts are largely in balance, with most EMs possessing strong and rising FX reserve buffers. Moreover, with limited foreign capital having entered EMs over the past two years and foreign positioning already quite light, less foreign capital is at risk of retreating from EMs as DM central banks move to tighten this cycle.

Risk Premium and Valuations:

11. In large part, as a consequence of the front-footed EM monetary policy response to the recent inflation surge and two years of limited foreign participation, many EM assets are now priced at excessively distressed valuations. In EMFX, the below chart from GS shows relative EM real carry differentials currently stand at levels that have only been observed a few times over the past two decades.

The elevated levels of real carry yield differentials are at EMFX REER valuation levels that are near twenty-five-year lows (per BofA) and EM equity markets are also priced at a discount to global markets.

En Garde Lagarde

The ECB joined the ranks of other DMs who have already shifted hawkish in the face of high inflation. However, in some EMs who were hiking last year, a dovish shift is now occurring. This divergence will be a key driver of macro returns this year

Last week may prove to be pivotal in terms of both setting the macro landscape for this year, and signaling what type of price action we can expect as we head further into the post COVID normalization cycle.

The most important development was in Europe, where the ECB delivered a surprising hawkish pivot that indicated that a hiking cycle may begin as early as Q3 this year. Specifically, President Lagarde in her press conference did not push back against market pricing for 2022 hikes, and stated that there was “unanimous concern” about inflation surprises, and that policy may need to be recalibrated in the coming meetings. Necessarily, 2022 hikes would also mean an earlier finish to the Pandemic emergency purchase programme (PEPP). This hawkish and data dependent stance was directly contradictory to her messaging at December's ECB meeting (where she said 2022 hikes are unlikely), and a significant shift from recent, detailed public comments from Isabel Schnabel and Chief Economist Lane.

Therefore, while European rates had moved higher in expectation of a policy shift at some point, the timing of such a shift was a major surprise to the market. This resulted in European rates having multi standard deviation moves higher in yield, with significant curve bear flattening and spread widening. Notably, German and Italian 2y yields had 4+ weekly standard deviation moves higher (with Thursday's move recording 6+ daily standard deviations in German 2y yields).

EUR 1y1y Interest rates have risen by 50bps in February month to date

There were also bearish developments for global fixed income in the UK, where the 4 members of the BoE voted for a 50bp hike, and in the US, where Friday's payroll data came out much stronger than expected, with employment increasing by 467,000 in January vs 150,000 expected. Further, record-high upward revisions to November and December accompanied this US data, and possibly most importantly, average hourly earnings surprised to the upside at 0.7% mom vs 0.4%e, with year on year wage inflation rising to 5.7%. US rates rose sharply on Friday, as this number suggests that both inflation risks remain tilted to the upside, as well as an economy with meaningful signs of strength. Both factors support a longer and steeper Fed hiking cycle in the context of the Fed's recent statements.

However, unlike the hawkish developments in core rates, EM central banks of countries that started hiking early in 2021 and are now nearing the end of their hiking cycle were dovish. In Brazil, the COPOM raised rates by 150bps, but signaled future hikes will not necessarily be at a pace of 150bps (unless inflation re-accelerates), the first dovish signal that indicates we are likely close to the end of the cycle. More surprisingly, the Czech central bank (one of the most hawkish central banks of 2021) surprised the market by signaling that even though there is still a chance of further hikes, they expect cuts to happen from the middle of the year. CZK 1y1y rates fell by 60bps Thu-Friday, and spread to German rates tightened by close to 85bps.

We think there are two key takeaways from this week's developments.

1. DM Central banks that have been dragging their feet are now forced to catch up as they are coming to terms with the non-transitory nature of inflation. This means higher volatility and the end of forward guidance. 

This ECB move is a significant pivot, but it is similar to the pivots we have seen in the US, UK, Canada in DM and Poland in EM. Ultimately, long-term forecasts of easing inflation pressures are overridden by the acute political and market pressure associated with rising inflation today.

Therefore we are now in the stage of “data dependency” in European monetary policy. This means much higher volatility, and that the skew of rates is to the upside in Europe as long as inflation remains high. What has also characterized other rate markets is that the market aggressively flattenens curves in response to inflation prints, and therefore the flattening we have seen in EUR swaps is likely to continue as long as inflation remains high. This is a more positive environment for the EUR but the picture is more mixed for European financials which may benefit from higher rates but may suffer in a weakening credit environment.

However, the more complicated issue in Europe is that bond purchases play two roles - a) easing financial condition and b) compressing spreads between core and peripheral EU country bonds. Reduced bond purchases, rising rates and greater volatility are likely to pressure spreads wider. Peripheral spreads have been much wider in recent history, and it will be important to track the tolerance level of the ECB regarding this dynamic.

2. 2022 is about trading the divergence in monetary policy cycles.

As we wrote on 1NOV2021 - “At its essence, what has happened in higher beta developed market rates markets over the last 6 weeks is what has already happened in emerging markets this year. Central Banks have delayed tightening due to a belief in the transitory nature of inflation, falling behind the curve, and then subsequently capitulating.” - Now, 3 months later, core DM central banks have capitulated. However, many EM central banks are well into their hiking cycles and in the case of the CNB, clearly signaled a cutting cycle.

This view is open to challenge in Czechia, especially if inflation remains high but the price action shows that as we head towards the end of cycles (where fiscal risks are contained), the convexity in rates may no longer be to the upside.

The key link between what is happening in DM curves and in EM curves is that the market does not believe we have seen a structural shift higher in underlying growth and relatedly, long term inflation dynamics. Therefore, in EMs which have already responded to the inflation shock, there is a lot of premium that can be unwound, supporting fixed income. If we see sustained positive real rates this will further support EM currencies.

Overall this remains an exceptionally volatile macro trading environment as divergences in cycles, data and policy reaction functions continue to deliver unprecedented variance in global markets. Forecast uncertainty is exceptionally high driven by the after effects of the pandemic shock, stimulus flood, renewed lockdowns, supply chain bullwhip and structural shifts within the economy, and this compounds shifts towards data dependency from central banks. In our portfolio we remain long European financials and travel stocks beta hedged, are paid in the front end of the US and have added shorts in German 5y rates following the ECB. Our systematic FX model is tactically long USD vs high yield FX and is long EURCZK, a trade that lines up with the policy shifts we have seen last week.

The Fed is HODLing Options

Powell confirmed the Fed prefers to remain long optionality, hawkish and data dependent. This is a regime shift from the era of the policy put and creates a more volatile market and interest rate environment for 2022 where the skew of risks for US rates is higher.

Chair Powell was re-nominated in November, and since that point the Fed reaction function has been hawkish. This really began with his first public testimony to Congress in early December. At that time, we noted that “Inflation is now a political issue, and it is logical that Chair Powell’s nomination over Lael Brainard comes with a mandate to ensure that price stability is given appropriate weight in policymaking…and the fact that they have shifted so soon after the taper announcement is indicative of a more responsive and hawkish Fed”.

This view was confirmed with Chair Powell's Q&A last week following the January FOMC. In summary

·        He explicitly stated that this cycle may be different from other cycles, noting that the economy and labor market are very strong, and that these differences vs other periods “are likely to have important implications for the appropriate pace of policy adjustment”.

·        This backdrop requires the Fed to be “humble” and “nimble” in its policy response.

·        He did not push back against current market pricing, rather he validated it, saying the Fed had been successful in its communication.

·        He pushed back on the idea that QT can operate to reduce the necessity of hikes.

Powell left little room for misinterpretation of his comments. Right now, the Fed is clearly worried it’s behind the curve and wants to retain the option to respond as forcefully as required to ensure that the price stability part of their mandate is fulfilled. Supply side pressures have not eased, inflation has broadened, and therefore the only way to deliver lower inflation is by cooling demand, which means tightening financial conditions.

In effect, this Fed wants to be long optionality, not short a policy put to the market. The dominant variable that will determine the Fed policy pathway is not the stability of equity markets, it is the path of inflation over the next 3 quarters. If inflation remains high (even if it eases somewhat from these high levels), this Fed will continue to raise rates, and this may come in 50 bp increments if the inflation outlook requires.

This confirms the significant shift that began in Q4 2021. This Fed has a hawkish reaction function, is data dependent, and is engaged in the opposite of forward guidance by retaining as much optionality to respond to incoming data as possible (supporting this point is that it has signaled QT and provided no details).

This policy stance is clearly volatility accretive for rates markets. As the Fed noted in a 2020 working paper, “forward guidance lowered market uncertainty about rates”. This, combined with the Fed's data dependency, the elevated level of macroeconomic data volatility, and difficulty in forecasting in the post-COVID world, means the range of outcomes for short-end US rates over the next 12-18 months is wide but skewed to the upside. However, for the long end, the market continues to flatten curves, implicitly signaling that the Fed will eventually get ahead of the curve too far and tighten policy in a way that reduces long term growth (the higher and steeper scenario we outlined in our note Jan 13). If this continues, it will be a key component of a bullish stance on long-end EM fixed income this year.

Overall, this is a more volatile global environment in aggregate, but one which is extremely interesting, as it is a regime shift from a prevailing macro-political environment, which was in place for most of the last decade. This environment continues to argue for a portfolio which is relatively beta neutral, but increasingly one in which a bearish trading stance may pay dividends in US equities (selling sharp intra trend rallies) and where the floor for US rate hikes this year is 4 hikes. Our portfolio reflects this: we are paid rates in the 2y-5y sector in the US and Poland, we are tactically long USDs vs EMFX, and have our equity views expressed in a beta neutral structure in Europe and Brazil.

COVID Pandemic

Global COVID cases rose marginally by +2.5% last week, with cases rising in Asia, Europe, CEEMEA, Latin America, and falling in the United States. In China, cases fell again last week to just 410 cases, nearly 75% below the recent highs seen in early January. Elsewhere in Asia, cases fell in India, where the recent Omicron wave appears to have peaked. In CEEMEA, cases remained low in South Africa, while rising to new record highs in Russia, Turkey, and Poland. Finally, Latin American cases hit new highs in Brazil and Chile, while falling in Argentina and Chile.

In Europe, cases rose again last week to record highs, with cases continuing to rise across Central and Eastern Europe, while falling in Western European countries such as the UK, Spain, and France. In the US, COVID cases fell sharply last week, with positivity rates also falling. The leading wastewater and Google trends data we track continues to point to a further decline in the US Omicron wave.

Data from the UK shows that the combination of high levels of vaccination and lower Omicron severity has now reduced COVID case fatality rates to levels approaching the seasonal flu. As evidence of lower-case fatality rates continues to grow, policymakers are increasingly shifting away from the restrictions that were commonplace over the last two years. In Denmark, where cases remain at all-time highs, policymakers are set to remove almost all COVID restrictions on Tuesday. Denmark’s Prime Minister Mette Frederiksen announced that thanks to the vaccine “superweapon” COVID-19 is no longer “threatening for society”, with the end of COVID restrictions set to help bring back “life as we knew it before COVID”. The pivot in policymakers’ response function is also seen in Emerging Markets. For instance, in Thailand, which last summer took a zero-tolerance approach, policymakers recently outlined plans to start treating COVID like influenza in the next six to 12 months.

Calvion's View: Despite near-term headwinds from elevated Omicron waves, we are constructive on the medium-term COVID outlook, with elevated immunity levels (from vaccines and infection), lower Omicron severity, increased antiviral treatment availability, and an increasing laissez-faire policy response, creating a strong set-up for further services recovery in the upcoming quarters.

Where is the Powell Put?

The Fed policy put is further from the money, and financial conditions are tightening. The period of US equity exceptionalism may be coming to a close and emerging markets are in position to benefit.

Last week was the worst week for US equities since March 2020. The S&P fell by 5.7%, a 2.7 weekly stdev move and broke the 200 day moving average for the first time since the COVID crisis, and for only the third time in the last five years. Losses were broad based with the Nasdaq and Financials falling by 6.9% and 7.4% respectively (EU Financials also had a 1.4 weekly stdev move lower). Following weaker than expected results Netflix fell by 23% on Friday and Bitcoin fell 15% between Friday’s open and Sunday mid-day while the Bitcoin - Nasdaq realised 30 day correlation reached 70%. Volumes were large and the break of key technical levels has resulted in additional CTA selling in key indices.

So what happened? The week began with weak results from investment banks, part of which is tied to the inflation in compensation costs, which undermined the financial sector, a well subscribed long in Long/short equity and directional portfolios. Furthermore with many of the high multiple, high growth stocks down 30-50% from their highs (85% in the case of Peloton), there simply isn't the same type of retail support for equities that characterised the bull market of 2020 and 2021. Indeed, we have seen a broad based derisking of “long-liquidity” proxies, as evidenced by the rise in correlation in meme stocks, tech and crypto in the last month.

Fundamentally, however, this week’s selloff reflects the rise in real and nominal rates, which made a local high at the start of this week. The market is coming to terms that the Fed is removing accommodation, and quickly, and this is likely to be much less supportive for US equities moving forward. However, while it is clear that the Powell Fed is not going to drive equity valuations in the way it did previously, the key question as we head into the Fed meeting this week is where is the strike of the Powell put?

The 2018 December selloff, where the S&P fell by 10%, resulted in a swift turn in communication and policy by the FOMC making 2019 a strong year for stocks. The difference between then and now was that a) the hiking cycle had happened b) inflation had begun to fall and was below target and c) the political pressure was intense from Pres.Trump to focus on the falling stock market. Today, the Fed has not even begun to raise rates, inflation is 7% and the no.1 political issue and pressure is to address the inflation dynamic as evidenced by Pres.Biden stating his support for the Fed expected plan to “recalibrate” their policy.

Given this, while we remain in this type of inflation environment, the clear risk is that the Powell put is much further from the money than we have seen in recent years. Taken together with higher rates, this means that both multiples have to come down and the left tail of the distribution is fatter. With that as a backdrop, the US equity risk premium should rise.

Paradoxically, the opposite may now be happening in emerging markets.

Last year was an annus horribilis for many EM equity and bond markets. Inflation brought sharp hiking cycles across EM, domestic political risk and fiscal slippage in Brazil and Chile compounded the moves by central banks and China combined a tight policy mix with a regulatory crackdown on the tech and property sectors. While S&P finished the year +29%, MSCI EM finished -5% and the year saw sustained outflows bringing valuations to historically low levels vs DM.

In many ways the tightening, re-rating and risk premium build that is happening in DM has already happened in EM and now we are beginning to see signs of incremental positive developments. Chinese policy easing has broadened and accelerated. In the last 10 days the PBOC has lowered the 7 day repo rate, the 1 year MLF rate (the first policy cut since April 2020), the banks loan prime rate and the 1 year loan prime rate alongside easing credit conditions for property lenders. In Chile, the recently elected President Boric appointed a orthodox, centrist Finance Minister. In Brazil there have been clear signals towards moderation by Lula, most likely the incoming President, while inflation is showing signs of peaking. This has been reflected in asset prices where Chinese, Brazilian and Chilean equities, three of the largest underperformers last year are all up on the year.

This is an extremely interesting macro set up. For the last number of years and especially since the pandemic US fiscal, monetary and pandemic response policy lead to US exceptionalism. There is now a clear case for this to be unwound and paradoxically, EM could be in position to benefit. The case for equities is likely one of outperformance if global equity beta is under pressure but if growth is slowing, inflation is falling then the type of inflows we saw into bond markets this week could be a sign of things to come.

In the near term, as we have been writing, the level of underlying volatility argues for a tactical and relatively beta neutral portfolio stance. Hence, we have reduced the portfolio’s aggregate equity beta. For EM however, we did not see any of the signs of weakness that characterised the rates shock in Q1 2021, in fact EMFX rallied and bond spreads tightened. The Fed this week will be key, if Powell is hawkish we would expect US equities to remain under pressure, curves to flatten and possibly a window for selected EM to outperform.

COVID Pandemic

World COVID cases increased again last week, with global COVID cases hitting new highs and rising in all regions but the United States. In Asia, cases rose in India while falling in China, where Chinese authorities continue to follow an aggressive zero-tolerance approach in the lead up to the upcoming Beijing Olympics. In CEEMEA, recent COVID waves receded in South Africa and Turkey, while rising on the week in Russia and Poland. Latin America rose across most countries in the region last week to new record highs. Despite the record cases many EM countries are currently recording, the impact of recent Omicron waves on fatalities and mobility levels remains generally benign compared with previous waves.

In Europe, cases rose to new record highs last week, with the Omicron wave broadening into Central and Eastern European countries. Similar to the trends seen in the rest of the world, Europe's COVID deaths relative to cases remain far below the levels seen in prior COVID waves, as the chart above illustrates. In the US, cases fell over the last week, with positivity rates declining to 24.8% from a recent high of 26.4% in early January. Leading data we track on the US COVID wave, including search data for COVID testing and symptoms, and regional wastewater data, suggest the downward trajectory in the US Omicron wave will likely continue over the next couple of weeks.

Consistent with the clear break in the relationship between cases and deaths seen globally, more studies this week came out supporting lower Omicron severity. A Nature preprint released Friday of hamsters found lower viral lung viral loads, lower pathology, and milder disease with Omicron relative to other variants - in line with previous studies that also found lower lung viral loads. A preprint released on Sunday from Portugal found that Omicron was associated with a 75% reduction in hospitalizations and a reduced length of average hospital stays after adjusting for sex, age, previous infection, and vaccination status.

Calvion’s view: We continue to see short-term headwinds from the elevated Omicron waves variant, disrupting mobility-sensitive demand and labor supply. In China, we also continue to see risks related to the zero-COVID policy - a risk that is particularly elevated in the coming weeks with the upcoming Beijing Olympics. In the medium-term, we view Omicron's lower severity as an accelerant in a transition that helps bring COVID towards an endemic, less fatal, and less economically relevant phase.