What will central banks combine?

Central banks will follow up on the hawkish speeches for now. But the rise in yields is limited, as self-correction mechanisms (risks to growth and financial stability) are taking hold. The analysis by Thomas Hempell, Head of Macro & Market Research at Generali Investments

Global venture assets are still struggling with the triple blow of the war in Ukraine, central bank tightening and Chinese asset closures. U.S. equities through mid-May recorded the most prolonged series of long weekly declines since 2021, before rebounding thanks to hope for stimulus from China and robust U.S. consumption data later this month.

However, significant changes are taking place in the markets. For most of 2022, inflation concerns – fueled by high commodity prices, supply bottlenecks and labor shortages – have pushed rates up and risk assets down, reversing the market correlations that have dominated since the mid-90s.

Yet, as we have argued in the past, rising yields are now colliding with self-correction mechanisms. Much of the global price increases are due to supply-side issues that central banks cannot control. The Fed, the ECB and other central banks have yet to show their teeth to prevent rising inflation expectations from turning into a wage-price spiral and persistent price increases. It is now reassuring for policymakers that inflation swaps have flattened.

This comes at the price of lower growth prospects. As the war in Ukraine continues to rage, high energy and food prices are holding back real disposable income and China is stifling growth in a desperate crackdown on zero-Covid policy. So fears of a more serious slowdown have come to the fore. However, recession is not yet around the corner, as households in Europe and the United States enjoy strong labor markets, consumers can tap into large surplus savings, and corporate balance sheets don't seem to hang in the balance at all.

On the other hand, U.S. retailers are struggling (Walmart and Target show piles of unsold inventory), and sales expectations from tech and media companies (including Snap and Netflix) show that the outlook for margins and corporate earnings has deteriorated. The Bank of England was the first major central bank to indicate in its May projections a real contraction in activity in 2023.

Prudent exposure to risk assets

Markets have already priced in a lot of bad news with their recent declines – both in terms of the global slowdown and central bank rate hikes – and the positioning appears to be extremely bearish, according to some tactical indicators. However, in light of current geopolitical risks (NATO/Russia, Taiwan), strong monetary tightening and slowing growth, we maintain a slight Underweight in equities and reduce our exposure in the High Yield segment. We expect to invest more in risk assets by the end of the summer if the Fed starts to become less aggressive, as we expect.

For now, we maintain our preference for high-rated credit, as the recent widening of the spread strengthens the buffer generated by high carry. A technical recession in the euro area cannot be ruled out, but it would take a severe one to justify a significant widening of Investment Grade spreads from current levels.

On government bonds, we are in favour of a slightly short duration position as the yield outlook has become more balanced. The euro has recovered its lost ground and could be set to rebound strongly later in the year. In the short term, we are cautious about quickly underweighting the US dollar, as tensions over Ukraine and its repercussions have yet to peak and the markets' forecast of seven rate hikes by the ECB through mid-2023 appears overly aggressive.

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