Will the summer be as hot in the markets as it is on the beaches and in our hot cities?
While our gas consumption entered low water months when inventories were generally being replenished, the specter of a Russian faucet shutting down added an additional source of stress for markets already characterized by the context of stagflation and monetary tightening. Even if, for whatever reason, the temporary closure of the Nord Stream 1 pipeline should be resolved quickly, this event reminds us of Europe’s double geopolitical and industrial vulnerability. If Russia has no interest in permanently withdrawing these foreign exchange earnings, it has a sword of Damocles against Europe, an energy deterrent weapon that should be waved further and which also keeps energy prices high.
This new saga maintains and reinforces a stagflation scenario that has now become consensus. In reality, economists and investors are weighing two main scenarios for the eurozone: a severe slowdown scenario, with the possibility of a limited contraction in GDP over a quarter or two, and a more severe scenario, with a recession entering in late 2022 or early 2023. The tipping point between these In both scenarios lies precisely whether the gas supply is maintained or not. Such a scenario should help keep inflation high until spring 2023, with inflation falling at a slower pace next year. What is new is that the 2-year inflation expectations in Germany are now significantly higher than in the USA. What a change of perspective after a decade of near-zero inflation in Europe!
This context further complicates the task for the ECB, caught in a dilemma between fighting inflation and managing fragmentation risk. Rationally, this should lead to reversing the doxa that prevailed in Frankfurt until recently (stop buying securities, then moderate and very gradual rise in interest rates); In fact, in this context, it now seems more relevant to quickly move interest rates into positive territory while continuing to purchase assets to combat the rise in sovereign risk premia. That is what the ongoing discussions are all about, with the market awaiting an announcement of an anti-fragmentation device for asset purchases.
Paradoxically, this deterioration in the macroeconomic outlook has not yet translated into lower corporate earnings expectations, which tend to adjust with some lag. This is another element to add to the long list of discrepancies in this atypical regime. For now, management news remains surprisingly confident in the resilience of earnings, both in terms of order books and margins, with a good ability to pass through cost increases to prices. However, this should alarm us in two ways. On the one hand, because it confirms the formation of a price spiral (the pricing power of companies was a good inflation signal in 2021). Secondly, because the slowdown in the growth trend and the decline in purchasing power will inevitably affect sales volumes, with the consumer and distribution industries being at the forefront.
After the shock of the conflict in Ukraine at the end of February, the stock markets went from a correction due to the rise in long-term interest rates to an adjustment in valuations (April correction) due to recession fears (June correction) over the summer, it remains to be seen whether the Top of the list of concerns will be margins and balance sheets. This only reinforces our strong belief since May in quality stocks and the return to profitable technology and certain defensive sectors after favoring value since early 2021. Dividend stocks also continue to do well in this regard, as they aim for above-inflation returns.
Good news in these troubled markets: the return to Chinese equities, a structural conviction of our firm that has been maintained in portfolios despite a largely renewed investment framework over the past year. In general, despite a very strong dollar, emerging market investments are a good source of diversification in this context. Many emerging and developed countries also wish for a lower dollar, especially given the phenomenon of imported inflation caused by the weakness of their currencies. Whether history will repeat itself (in the direction of a new Plaza agreement like 1985?) remains to be seen, but this is one of the elements to watch over the coming months and reflects the Fed’s stance, albeit its own Policies that could affect the enforced normalization has been destabilizing for the rest of the world.
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