Muzinich Weekly Market Comment: On the lookout

July 8, 2024

In our latest roundup of developments in financial markets and economies, we explain why credit investors should remain watchful for three sources of risk.  

Despite a positive start to the month, signs of dislocation can be seen across markets. US Treasury yields fell due to yet more soft economic data, seemingly paving the way for the Federal Reserve to begin easing policy in September. Conversely, German bund yields pushed higher as central bank rhetoric turned hawkish.

All credit markets have gained so far in July. US investment grade has outperformed, helped by falling Treasury yields, while Europe has been the pick in high yield as price action continues to recover following the widening seen after the surprise announcement of elections in France.

Hawkish commentary from both the European Central Bank and Reserve Bank of Australia set the tone for the US dollar to depreciate against G10 currencies, while the Brazilian real was the outperforming emerging-market currency after its finance minister announced spending cuts.^[1] The rally in commodities and equity markets has been broad based, with both the MSCI World and MSCI Emerging Markets indices setting fresh two-year highs (see Chart of the week).

Calm before the storm?

Investors, particularly in credit, always need to be on the lookout for anything that could disrupt the positive trajectory in markets. For a significant correction, there would need to be some kind of crisis, where a tail risk becomes the consensus view. We can separate the potential causes of a correction into three broad categories: economic crises, event crises and financially engineered crises.

Let’s briefly address the last two of these. A crisis that is financially engineered can be long in the making. Such events include asset price bubbles, currency crises, debt leverage crises, and banking crises.

An event crisis can be defined as a sudden 180-degree turn from a state of confidence and certainty to one driven by fear and the unknown. There are three buckets to this category: geopolitical events, social/humanitarian events and domestic political events.

Under geopolitics, some of the more obvious risks would be an escalation in the current crisis in the Middle East, or China taking clear sides to help Russia push the conflict against Ukraine in its favour, while simultaneously circling Taiwan with military force. Under humanitarian, potential risks could include a nuclear reactor failure, natural disaster or new global pandemic.

On domestic politics, fiscal responsibility will be in the spotlight for majority governments such as in the UK and Mexico, while in Europe, countries with minority governments could refuse to implement the austerity measures needed to bring budgets in line with the bloc’s fiscal rules. It is a small but not inconceivable risk that this could once again trigger a potential breakup threat to the EU.

Surprise in France

The second round of the French elections, which resulted in a hung parliament, highlighted again that market participants should be prepared for all eventualities. Against all odds, the transfer of votes across candidates was favourable to the left wing Nouveau Front Populaire (NFP), which became the leading parliamentary group by seats. Ensemble, led by President Macron, came second and the far-right National Rally, which led after the first round, finished third. As of now, no group enjoys an absolute majority or can claim to have enough backing to form a government.

Two scenarios seem plausible at this stage. The left wing can assemble close to 200 seats and claim to be in position to govern. For various reasons, this may appear the most logical outcome but would be difficult to implement. The NFP was only formed on June 9 and is a mix of vastly different flavours of left-wing politics rather than a unified alliance.

The second scenario would see the centre being enlarged to include the traditional right and support from moderate left wingers who are afraid of the extreme left dominating the NFP. Such an alliance could gather 220-220 MPs, but here too, the formation of such a coalition would hardly be smooth and easy.

A short-term solution could be for a transitory government that would last through the Paris Olympics and give time for a centre-left collation to be formed. In such a scenario, expect protests and noise from the far left La France Insoumise party.

Overcooked

Outside of domestic politics, the risk of an economic crisis is the most discussed by investors, with an army of perma-bears willing to call the top of the economic cycle. Predictive indicators cited by bears include inverted government bond yield curves, and rising unemployment and credit delinquency levels. The common thread linking the three is a perception that central banks have overcooked their monetary tightening bias in terms of size and longevity.

Right now, a soft economic landing remains the consensus view, which suggests central banks successfully managed to bring inflation back towards target without damaging economies. However, the US Federal Reserve’s continued ‘higher-for-longer’ stance, which has held firm since a succession of strong inflation releases in Q1, is starting to create friction.

As we have noted previously, US economic activity has not met expectations of late and the contraction in activity has further accelerated since the middle of June. The Federal Reserve of Atlanta’s GDPNow model, a widely watched estimate of real GDP growth, now has Q2 GDP growth falling from 3% to 1.5%.^[2] Meanwhile, the official US unemployment rate of 4.1% at the end of June is above the Fed’s projected year-end level.^[3]

In the minutes for the June meeting of the Federal Open Market Committee, it seems many Committee members have been surprised at the recent slowing of economic activity. At the same time, “participants noted that progress in reducing inflation had been slower this year than they had expected last December”.^[4]

Out of sync

While the Fed continues to agonise over inflation and when to cut rates, countries in emerging markets and Western Europe have reached, or are within touching distance of reaching, inflation objectives and already started the process to unwind restrictive policy. However, a desynchronisation in policy cycles from the US is uncommon and could have unintended consequences. Higher US rates versus other major economies would logically attract global capital flows and the dollar should appreciate.  

Aware of this imbalance, central banks are looking for reasons to stall the normalisation of monetary policy. China said further monetary policy loosening will be limited by the Fed’s stance, while Western Europe has highlighted concerns over service prices. In Eastern Europe, concerns centre around the removal of utility subsidies, while central banks in Latin America cite currency volatility.

The most obvious crisis to watch out for is the ‘not so soft landing’, which in the worst case could lead to stagflation in some countries. On that, the good news for investors is that central banks have plenty of firepower to now loosen policy after the restrictive actions taken in the past two years.

Chart of the Week: Global and EM equity indices hit two-year highs 

Source: Bloomberg, as of July 5, 2024. Index performance is for illustrative purposes only. You cannot invest directly in the index. Indices selected provide best proxy for highlighting performance of global and emerging market equities. For illustrative purposes only.

References

[1] Reuters, ‘Lula approves spending cuts to meet Brazil's fiscal framework,’ as of July 4, 2024
[2] Federal Reserve of Atlanta, as of July 3, 2024
[3] US Bureau of Labor Statistics, as of July 2, 2024
[4] Federal Reserve, Minutes of the June 11-12 FOMC, as of July 3, 2024

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

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. The opinions expressed by Muzinich & Co. are as of July 8, 2024, and may change without notice. All data figures are from Bloomberg, as of July 5, 2024, unless otherwise stated.

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