Weekly review 30 May: Continental shift on the markets


What tools has the ECB unleashed to fight inflation? How has the relationship between the fixed income and equity markets changed? And what changes have been seen in the US consumer product sector?

What has been happening in the fixed income market last week?

In recent weeks we have seen that the greatest upsurge in the fixed income markets has come to an end. The US long-term government bonds have begun to behave more normally and the negative correlation of interest rates with the equity markets has returned. Rising interest rates used to drive stocks down, but the relationship has reversed.

The TINA principle (There Is No Alternative) that held sway on the markets for some time is now giving way to the TARA principle (There Are Reasonable Alternatives). Investors can expect to find some alternatives with reasonable returns to equity investments even in liquid fixed income.

How has the geographical diversity of the equity markets changed?

In the early part of the year there were moments when equity returns diverged significantly between different geographical areas. In recent weeks, we have returned to a situation in which the returns from the different areas’ equity markets are again very much the same for euro investors, at a lower level than at the start of the year. Over the past month especially the US equity markets have fallen to the same level as other markets, driven by the depreciation of the dollar.

From an equity investment viewpoint, more economic continents are shifting at the moment than in decades.

What tools has the European Central Bank unleashed to fight inflation?

Throughout the spring, the ECB has been a few steps behind the Fed in its monetary and interest rate policy. However, now the ECB President Christine Lagarde seems to have woken up to the need to tighten EU monetary policy. The ECB has communicated clearly that it will end the negative interest rate period in Europe through the July and September meetings’ interest rate hikes. Additionally, the ECB has announced the end of its security purchase programme before the first interest rate hike, ending the expansionary monetary policy. The main goal of this turnaround is controlling inflation.

And what is the Fed doing?

The Fed on the other hand has been tightening the monetary policy environment in the USA for several months. The monetary policy rhetoric of Fed Chair Jerome Powell continues to be aggressive but the markets are anxiously anticipating the slightest sign that the rhetoric will ease up. This would require more moderate inflation, for example through a tightening financial environment. Sufficient tightening of the financial environment can be assessed based on the equity market or corporate bond market levels. The presumption is that a significant market stress would launch a reversal in monetary policy in a more expansionary direction (the Fed put) and would result in a positive market turnaround.

The central bank measures are based on inflation development and the possibility of a global recession. Although the economic figures from Europe and the USA have shown cautious signs of improvement, the possibility of a recession has been present in market rhetoric in recent weeks. While interest rates are being raised, global real income is negative and the consumer product sector is experiencing hardship. Recession expectations have not become mainstream yet; for instance Goldman Sachs still considers it more likely that a recession will be avoided.

How has China’s central bank reacted to the country’s “impossible” Covid-19 policy?

China’s strict Covid-19 measures have significantly slowed down the country’s economic growth. As a result, the People’s Bank of China has made an effort to lighten the country’s economic distress with expansionary measures. The PBC is now the only major central bank taking an expansionary path instead of tightening.

What should we keep an eye on in the US and European economies in the next few weeks?

In addition to inflation, the consumer product sector and housing markets will be major indicators in the US economy in upcoming weeks and months. Major retailers like Walmart and Target have suffered as a result of the declining purchasing power of consumers in an environment where prices are rising. As goods are not selling, retailers have seen their inventories balloon. When the companies eventually sell their stocks at a discount, the consumer market may experience a deflationary shock.

On the US housing market, mortgage interest rates have doubled in a year and a half. Meanwhile, house sales have dwindled. The housing market is not yet in an acute downward spiral, but it is a significant factor also from investors’ viewpoint.