Muzinich Weekly Market Comment: Peace sign

February 17, 2025

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In our latest roundup of the key developments in financial markets and economies, we consider the implications of a potential end to the Ukraine-Russia conflict.

The positive start to February continued last week: equities and commodity prices were up, corporate credit spreads tightened, and the US dollar weakened. On the political front, markets digested another stream of tariff headlines, while the stickiness of inflation remains a key concern on the macro side. The one area that deviated from its previous trajectory was government bonds, with yields rising across the world, particularly in Europe.

In the US, the catalyst for rising yields was an upside surprise to January consumer price data, supporting the Federal Reserve’s decision to adopt a wait-and-see approach before adjusting monetary policy. Core consumer prices in January rose 0.45% (vs. 0.3% expected), pushing the year-over-year increase to 3.3% (vs. 3.1% expected),^[1] with particularly strong service-sector inflation and used car prices.

If we isolate the inflation component from the 5-year US Treasury yield, investors are signalling that inflation expectations are on the rise. Since bottoming in September, the breakeven inflation rate embedded in 5-year Treasurys has risen from 1.88% to 2.65% (see Chart of the Week). This could put pressure on the Fed to keep price expectations anchored.

Relief in the UK, but can it last?

In the UK, to the relief of Chancellor Rachael Reeves and the Labour government, the economy unexpectedly grew in the fourth quarter of last year. Gross domestic product (GDP) rose 0.1%, a slight acceleration from zero in Q3.^[2] Growth in December, which accelerated 0.4% month-on-month, was driven by strong performance in pubs and bars, wholesale trade, film distribution, machinery manufacturing, and the pharmaceutical industry.

Reeves will hope this momentum has continued into 2025, after a leaked report by the Office for Budget Responsibility (OBR) suggested the government’s fiscal headroom has eroded.^[3] The OBR’s assessment is based on slower growth and higher gilt yields, leaving Reeves with a difficult choice to increase taxes or cut spending. Either option could hinder the government’s growth agenda and worsen economic conditions.

A call for peace

In mainland Europe, government bond investors watched nervously as natural gas prices reached a two-year high,^[4] while storage levels fell below 50%.^[5]

However, market concerns quickly eased after US President Donald Trump announced that he and Russian President Vladimir Putin had agreed during a phone call to begin negotiations to end the war in Ukraine.^[6] The initiative to start the process of ending the conflict should be welcomed, but reaching an agreement acceptable to all sides will be no small task.

In the optimistic event an agreement can be reached quickly, the outlook for Europe — particularly Eastern Europe — would brighten. A secure flow of gas through Ukraine would likely be restored, marginally increasing supply and stabilizing prices. This was reflected in the price of gas falling from €58/MWh to €50/MWh after Trump’s announcement.

Peace would boost confidence across the continent, potentially encouraging consumption, investment and capital inflows. This was evident in the region's strong currency performance last week, with the euro appreciating over 1.5% against the US dollar, and Eastern European currencies such as the Polish zloty and Hungarian forint gaining more than 2.5%.

Steeper curves

The underperformance of European government bonds may partly be attributed to expectations surrounding Ukraine’s reconstruction and European defence spending, both crucial for reaching an agreement and acting as positive catalysts for growth. But as these spending programmes will likely be financed through government bond markets, the increase in supply and debt levels could further steepen European sovereign curves.

For investors seeking exposure, emerging markets may be well positioned to benefit from a resolution. Among developed markets, European risk assets might continue to rally; last week, European high yield outperformed among credit sub-asset classes. Meanwhile, France, Spain and Switzerland joined the club of equity markets to report double-digit returns year-to-date.

At a more granular level, risk assets linked to cement, steel and other construction materials could gain from Ukraine’s reconstruction. European chemicals could benefit from increased supply and lower gas prices, airlines might see higher traffic volumes due to the reopening of routes, and the defence sector would benefit from the expected increase in government spending.

Chart of the Week: Are US inflation expectations becoming unanchored?

Source: Bloomberg, US Treasury Breakevens, as of February 14, 2025. For illustrative purposes only.

Past performance is not a reliable indicator of current or future results.

References

[1] US Bureau of Labor Statistics, ‘CPI January 2025,’ February 12, 2025
[2] Office for National Statistics, ‘GDP Q4 2024,’ February 13, 2025
[3] Bloomberg, ‘Reeves Set to Break Fiscal Rules After Outlook Cut by Watchdog,’ February 11, 2025
[4] Intercontinental Exchange, TTFG1MON OECM Index, as of February 14, 2025
[5] Gas Infrastructure Europe, as of February 14, 2025
[6] BBC, ‘Ukraine war talks start now, Trump says after Putin call,’ February 12, 2025

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies are for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of February 17, 2025, and may change without notice. All data figures are from Bloomberg, as of February 14, 2025, unless otherwise stated.

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