The fluid macro environment over 2022 has been an excellent playing field for macro investors as the shifts in sovereign fundamentals have not been this aggressive since before the financial crisis. Amidst all the volatility, there has been defined macro regimes producing market trends that flexible portfolios can capture. However, to be successful, portfolio constructs have had to change and adapt as the market’s views on growth and inflation have not remained static.
The pressure facing developed market economies in 2022 has come from both external and internal sources. The sanctions that followed Russia’s invasion of Ukraine has excluded the largest fuel producer from the global economy and has heralded a new era of expensive and inelastic global energy markets. It marks a very big shift towards the end of globalisation as cheap and easily accessible energy is not available anymore. Expensive energy hitting strong economies drove inflation higher and trade balances lower for those without adequate domestic energy resources. Looking more broadly, expensive global resources appear permanent, as a lack of investment in recent decades in resource extraction and energy infrastructure and the green transition compound problems.
A shortage of labour in the West has made the situation worse, creating very tight labour markets. Labour is suffering from weakened post Covid health services, tighter immigration policies and, for demographic reasons, more retirees. In conjunction with expensive energy the wage / price spiral risks are real. As goods prices have eased back in recent months on the back of improving supply chains, services prices have boomed as economies reopen. This classic macro imbalance drove a singular response from central banks: to crush demand.
The weaker growth this produced combined with deteriorating trade balances for developed market commodity importers and the ‘cost crisis’ meant currency markets took the strain, as expensive imports damaged private sector balance sheets. Whilst the move in currency markets favoured the resource rich economies, the sell-off in the bond market was not on firm ground.
The high inflation levels reached over the summer morphed into intense recession risks as high prices destroyed both consumer and business confidence. Commodity markets also succumbed to weaker growth providing some welcome relief. However, as the Ukrainian conflict intensified, and energy became weaponised, global energy prices fractured with European natural gas prices surging as oil fell. As recession concerns grew, global bond markets staged an impressive recovery over the summer months. Whilst central banks secretly enjoyed this demand destruction, governments were not pleased. The recent fiscal spending announcements to support economies changed the market calculus dramatically. As governments took the problem onto their balance sheets stimulating the private sector, inflation once again became front and centre.
This shifted the strain from foreign exchange to the bond markets, resulting in a dramatic bond sell off in recent weeks. Bond investors need higher returns to fund governments and support this new policy mix at a time demand needs to fall, not rise. Central banks need to counter this by getting policy rates higher. In the UK, the fiscal injection was untargeted and stimulatory at a time inflation hovered above 10%. With the central bank reticent to hike, sovereign risk rose as the gilt market, led by the long end, came under serious pressure. The UK might have the highest external funding needs but it’s also a window into what is impacting all energy importing economies. Poorly constructed fiscal policy working against central bank actions is clearly not a good mix for the sovereign bond markets.
This opens a new chapter for markets in 2022, one in which financial risks are now a problem, alongside the existing inflationary supply and demand imbalance. European governments are now writing blank cheques to cover energy costs dragging their own fiscal balances into the firing line. Sensible government policy has never been so vital. Whereas higher energy had a weakening impact on private sector demand previously, it does not have the same effect now, as governments absorb the cost. If energy prices move higher still, to keep the confidence of the markets tighter central bank policy and government austerity measures will be needed. If this doesn’t happen, inflation will not come under control and reliance on external funding sources will intensify. This will prove very difficult for some policymakers given the hardship this imposes on the wider population. Markets will force borrowing costs higher to make sure central banks and governments respond adequately.
This is also where the US could get dragged down by European problems. As often is the case in a financial crisis, the globally connected financial system transmits problems across the globe. A deterioration of European sovereign risk will likely see a scramble for US dollars everywhere to pay for expensive energy and in some cases intervention in domestic currencies. Either scenario will lead to a selling of US Treasury bonds and an uncontrolled tightening in US financial conditions. That’s a feature markets have seen time and time again (the most extreme example being the Covid lockdown volatility in 2020) as US funding its massive current account gets dragged into the mire due to intense global dollar demand. The new Federal Reserve US Dollar lending facilities (Federal Reserve US dollar swap lines and Standing Repo facility) will unlikely be able to prevent it. The steep decline in global sovereign reserves held at the Federal Reserve ominously show this is already happening alongside a deterioration in US Treasury liquidity. The unprecedented global condemnation of UK policies in recent weeks is a recognition of these stresses.
This all adds another dimension to a very complex policy backdrop. The central banks continue to try to push down growth to combat inflation with very limited success so far. This is being countered by Russia continuing to fan the flames to boost energy prices (Nord Stream pipeline explosion) to keep up the pressure for winter 2023. Western sanctions on Russia only work to boost energy prices further. In direct geopolitical conflict with the US, OPEC cutting production to boost oil prices is an alarming new development supporting the Russian agenda. Finally, European governments have unleashed the new financial risk fault line with untargeted stimulatory policies.
Tight energy and labour markets will continue to dominate with government debt the loser until global growth is crushed, unemployment rises, and energy prices decline across the board. Rates have moved higher dramatically in 2022 but still none of these factors have been fulfilled. Unless something on the geopolitical stage changes, high bond yields are required to achieve these outcomes making a persistent bond rally unlikely. Western media focus on Russian battlefield losses ignores the financial weaknesses being exploited by Russia against the West. The silver lining of course is Putin is unlikely to escalate into tactical nuclear weapons given that his leverage is improving, not declining, as most think.
A dividing line between sovereign bond markets with natural resources and those without is being drawn, blurring the previous ‘developed’ and ‘emerging’ market classifications. Less inflation and reduced fiscal stress for resource independent countries support their bond market valuations but for the others, higher yields are needed. As the western bond market bubble bursts, both default stress and housing market pain will be accentuated, impacting growth outcomes. Whilst the broad-based and front-loaded bond sell off might soon reach its climax, macro-economic divergence in economies is only increasing and how central banks and politicians react to their own unique circumstances will determine yield levels, curve shape and foreign exchange prices.
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