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Investment Outlook: ECB rules out recession, stocks and bonds decorrelate

Gaurav MehraManaging Director and Senior Partner - Head of Macro Trading

Investment Outlook: European Central Bank (ECB) rules out recession, stocks and bonds decorrelate

Positive eurozone rates within four months

In this environment of multi-decade levels of inflation and rising interest rates, over-aggressive monetary policy tightening by central banks remains the biggest investment risk. This said we are clearly approaching a potential ‘tipping point’ in markets.

European Central Bank (ECB) President, Christine Lagarde, underlined its determination to fight inflation and, importantly, that it sees no sign of a recession in the region. This outlook is based on low unemployment levels in the eurozone, solid household savings post-pandemic, and expectations for the first strong tourist season in three years.

Mrs Lagarde also said that she expects interest rates in the eurozone to reach positive territory by September. That implies rate hikes of 25 bps (0.25%) at each of the ECB’s July and September meetings.

We believe that European inflation is now likely to be close to peaking and should begin to taper off in September, once the higher cost of borrowing begins to take effect. For now, any threat of ‘stagflation’ - that is rising inflation and stagnating growth - looks overblown.

Last week Federal Reserve Chair Jerome Powell said that he is prepared to hike interest rates in the US even at the expense of economic growth. In the short run, we expect markets to remain volatile until the Fed reports again on 15 June, when it is expected to raise interest rates by another 50 bps.

Stocks and bonds are decorrelating again

As we have set out recently, outside a recession, it is rare to see stock indexes fall more than 20%. Last week, the S&P 500 briefly recorded a year-to-date fall of one fifth, before rebounding, as we expected. More widely, equity valuations continue to look increasingly attractive.

After this year’s selloffs across both bond and equity markets, we are now seeing a regime shift. The two asset classes are finally starting to show signs of diverging, meaning that we are heading back to a more classic environment in which demand for bonds increases as equities decline. We believe that, as we have communicated in recent weeks, this represents an opportunity to add fixed income exposure to portfolios.

Dollar weakness is positive for risk appetite

Similarly, after six consecutive weeks of falls in the benchmark US S&P 500 index, during which investors looked to the dollar to offer a haven, the euro has begun to recover against the US currency.

In response to today’s statements from the ECB the euro strengthened to trade around 1.07 against the US dollar. If the euro continues to stabilise against the dollar, it would be positive for risk appetite as it would suggest that investors are becoming less fearful and prepared to deploy their cash again. In addition, we see that credit spreads, which widen when lenders believe the risk of default is rising, are still much narrower than in previous recessions, for example in 2008 and again at the start of the Covid pandemic in 2020.

Finally, a reminder that China’s authorities continue to inject liquidity into the country’s economy to stimulate growth. The Chinese equity market experienced a rally, before selling off again, but with multiple levels of fiscal and monetary support worth an estimated USD 5 trillion, China is evidently determined to support its economy. That of course matters for the rest of the world because it should eventually ease inflationary pressures caused by the logistical and supply-chain disruptions of China’s Covid lockdown strategy this year.

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