Russia - Ukraine - Hoping for the best
The gambler’s corner is often described as a situation where the bets become ever more risky given that the gambler has his back to the wall. The military calls it vertical escalation, when one party seeks a way out by ever more aggressive moves. Russia has its back against the wall faced with heavy sanctions and, for now, very limited support from China. Over time, as imports into Russia become more expensive and harder to find, discontent is likely to spread in the population forcing the government to find a new narrative. The US government speculates on the use of non-conventional weapons, while the market hopes for the best, namely the start of serious negotiations. In essence, the market believes Russia will back down and find a compromise in Ukraine. The longer Russia waits, the stronger the impact of the sanctions including very elevated interest rates, suggesting the market is probably right to be cautiously optimistic. Indeed, Russia announced a more limited goal to ‘liberate’ the Donbass region. The question now is whether Russia will accept Ukraine’s claim to neutrality.
Eurozone – Stabilization of fixed income
The European economy is expected to grow at 3.3% this year and 2.5% next. The risk is that households over-react in the coming weeks to headlines regarding the war in Ukraine and much higher oil prices. Some of this can already be seen for example in the collapse of the German ZEW expectation for growth. This shock though, like that of higher interest rates in the periphery, should then fade away.
The ECB is faced with the rising risk of a wage inflation spiral as households living from paycheck to paycheck change jobs or ask for higher wages. This means that the market is expecting a faster pace of rate hikes starting in Q3 when the APP program ends. Note that it is a delicate exercise for the ECB as the Eurozone is also suffering a supply shock from elevated energy prices and a loss of access to the Russian market. Conversely, US demand and eventually Chinese demand should be robust. In a more prudent risk environment, the odds are that European fixed income should find an increasing bid from High Yield to the European periphery. At the same time, European equities are attractively valued.
USA – Overheating
In the United States, the concern is that the Fed will stay for too long behind the curve forcing it to overtighten and leading to the risk of a recession. History suggests this tends to happen as the dynamics of an abnormally hot labor market are difficult to forecast. The difference this time around is that the midterm elections are ahead of us with inflation a major topic. This means that for a while the Fed will probably try to get ahead of the curve and it may well continue with an eye to the presidential elections. That suggests the terminal interest rate should move higher, but a lot is already priced in. This implies an ample opportunity set in fixed income and some prudence in equities (e.g. Growth style) where valuations remain expensive. Equities in contrast to fixed income assume a long and smooth path of growth ahead.
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