4 important points to pay attention to

Monthly review by Nicolas Blanc, ELLIPSIS AM Distribution Manager.

Nicolas Blanc, Distribution Manager, Ellipsis AM

Key points

  • The FED is accelerating
  • PMIs fall in Europe and the US… and other signs of a slowdown
  • China is turning back
  • Italy: bis repetita?

The sequence of events in June gradually confirmed the deterioration of the general economy.

Bad inflation news prompted the Fed to raise rates by 75 bps, raising fears that it will have to slow the economy significantly to get inflation under control. Industrial metals – highly sensitive to economic conditions – fell sharply during the month, as did agricultural commodities. Even oil, despite its recent recovery, is falling. The moves come even as China rebuilds its economy. Finally, PMIs in Europe and the US were published well below expectations, and if they still remain above 50, the loss of momentum is very evident, while consumer confidence deteriorates further.

Therefore, the question no longer arises about the slowdown, but about its scale. Other positive arguments relate to the good health of the private balance sheets of households and companies, as well as financial institutions, two elements that could protect us from the contagion and amplification effects caused by the forced deleveraging and lock-in of the financial sector. The soon-to-open earnings season will no doubt be instructive about the resilience of the private sector.

The FED is accelerating

An increase of 50 bp. historically consistent with rapid tightening rates for the Fed. However, the latter finally decided to raise its rates by 75 bps. in June after worsening the inflation forecast. The price index for May was actually published 0.3% above expectations (+8.6% for the year and +1.0% for the month), a significant difference that further pushes back expectations of peak inflation. The University of Michigan survey also found that households also adjusted their perception of long-term inflation upward. Finally, the job market shows no signs of letting up, and creations are beating expectations.

With this unexpected decision, the Fed risks overdoing it and causing an unnecessary economic slowdown. We also see inflation expectations fed by the swaps market falling sharply, and signs of a slowdown are piling up (see below) and financial conditions are tightening. Therefore, it could be demanded to rectify the situation from the beginning of next year, as the markets expect.

2022.07.05.  Federal funds
2022.07.05. Federal funds

Eurozone and US PMIs fall… and other signs of a slowdown

PMI fell sharply in the Eurozone, with the composite losing 2.9 points to 51.9, when the consensus was 54. The new orders component posted 50, down 3.3 points, marking the end of the optimism that has prevailed so far, while stocks have risen significantly, and this combination does not bode well for future demand. However, these figures should be interpreted in the light of the surrounding geopolitical context, in particular the energy crisis that threatens Europe. The current level of the PMI, which nevertheless remains in expansionary territory, may indicate that the economy is able to mitigate future shocks rather than avoid them.

Another element to note, the survey reports a reduction in inflationary pressures and improvements in production chains (price components and delivery times). While these elements are primarily an analogue of a slowdown in demand, they help ease pressure on the ECB.

The situation is comparable in the US, where the composite PMI was published at 51.2 against the expected 53.0. The magnitude of the fall is even greater for manufacturing activity, which fell from 57 to 52.4.

Household confidence readings are also deteriorating, with some posting historic lows. The contrast between current conditions and future projections is another sign of an impending slowdown.


China is turning back

In a phase of confrontation with advanced economies, the Chinese economy is accelerating, driven by the breath of recovery of its economy after a period of severe health restrictions. The latest PMIs were posted sharply higher (+3.6 for the manufacturing component and +5.2 for the services sector), making China the only area with positive economic momentum.

This is certainly a very positive element, as it is likely to soften the shock experienced by emerging economies. However, this is difficult to count on, as China’s structural weakness remains:

Given the low level of vaccination and acquired immunity, the risk of a new wave and associated medical measures is very high.

The real estate crisis is not resolved, far from it. The state avoided a major crisis in the development sector with aggressive support measures, but the dynamics of this market remain negative in terms of prices and sales. The outlook for private players is very bleak, with large unsold acreage, public mistrust and unacceptable credit margins.

Finally, China is highly dependent on external demand, especially from emerging economies. Thus, the likely slowdown of the latter will in turn affect the Chinese economy. Tensions between the West and Russia, China’s ally, could worsen over possible trade sanctions.

2022.07.05.  PMI China

Italy: bis repetita?

The ECB’s peripherals announcements at the start of the month were somewhat flawed, leading to very rapid increases in spreads and real rates, a configuration that may have reminded us of the Eurozone crisis.

The position of the ECB is now very uncomfortable as it has to fight both inflation (restrictive stance) and fragmentation (targeted accommodative stance). She confirmed her intentions, but did not specify how she intends to proceed specifically, which should be revealed at the July meeting.

The flexibility to reinvest existing programs (PEPP, PRPP) is one way, but probably not enough given the scale of the problem. An ideal instrument should be able to mobilize unlimited amounts for an indefinite period to discourage any speculation. The counterparties will probably include sterilization (withdrawal of liquidity created by the sale of other assets) and some form of covenant, probably less restrictive than OMT.

Finally, note that today’s situation is very different from the situation during the 2012 crisis: – There is a consensus that allowing the situation to deteriorate would be counterproductive – the principle of monetary support for sovereign markets has been confirmed by the Court of Justice of the EU and finally Italy has caused a significant decrease in the average rate its debt during the period of monetary support, and it will not rise again quickly.

2022.07.05.  Sovereign rates

The content of this document should not be understood as investment advice or within the meaning of the European Market Abuse Regulation VT No. 596/2014 of April 16, 2014 or in the sense of the directive MIF2 2014/65/EU of May 15, 2014. Any instruments or issuers mentioned are intended solely to illustrate past situations and events in this context should not be construed as forward-looking. These opinions are derived from the experience of Ellipsis AM managers, realized in their management of funds and mandates. These portfolios may be exposed to the sectors, strategies and instruments mentioned in this document, and future management decisions are not limited to the comments and analyzes reported and may even end up in the opposite direction.

Credit risks: UCI is more exposed to the risk of rising rates in the bond market. Such movement causes the prices or valuations of the bonds to fall and, as a result, the net asset value of UCI to fall, which is not covered by any guarantees or protections.