3 Forces Shaping May Business And Investment Climate; FX Update

 | May 02, 2022 01:15AM ET

The general contours of the business and investment climate are being shaped by three forces. First, Russia's invasion of Ukraine and the sanctions boosting price pressures and slow growth. It was a supply shock. Even before the war, countries had begun stepping back from the powerful monetary and fiscal support provided during the pandemic.

Second, China's response to its COVID outbreak is slowing the world's second-largest economy. It threatens supply chains but also a demand shock. The knock-on effect has seen a reversal of fortunes for previously favored "commodity currencies."

Third, the market understands that the Federal Reserve has made a hawkish pivot. It now sees the year-end Fed funds target at 2.85%, up from around 0.80% at the end of last year and 2.40% at the end of March. In addition, a relatively aggressive reduction of the Fed's balance sheet, in the current context, is also tantamount to some more tightening, even if economists differ on how much. This has helped send the US dollar broadly higher. 

While the fog of war and the impact of China's COVID policies reduce visibility and boost uncertainty, they have spurred an acceleration of rate hikes. Among the high-income countries, the Reserve Bank of New Zealand and the Bank of Canada hiked rates by 50 bp. The Federal Reserve is expected to match them in May.

At the same time, several central banks, including the Reserve Bank of Australia, the Reserve Bank of New Zealand, the Bank of England, Sweden's Riksbank, and the Bank of Canada, have begun allowing their balance sheets to shrink by refraining from reinvesting the full amount of the maturing proceeds. At the May 4 meeting, the Federal Reserve will announce its starting date. After a short rolling start, the Fed is seen allowing the balance sheet to shrink by $95 bln a month ($60 bln of Treasuries and $35 bln MBS). This is almost twice the Fed's pace in the 2017-2019 period. 

The aggressive reduction of the Fed's balance sheet spurred an abrupt steepening of the US 2-10-year yield curve in the first half of April. The inversion that provoked so much discussion was erased, and the 40 bp difference that it reached was the steepest slope since late February. The curve finished the April near 20 bp. We suspect the curve will become inverted again. The swaps market shows that the terminal rate for the Fed funds will be around 3.25%-3.50% in this cycle, suggesting that there may be value at the long end of the curve when yields are near 3%. However, the two-year note yield may need to climb closer to the anticipated peak in Fed funds.

Our concern is that something "breaks" before the Fed can lift rates to those levels. The combination of aggressively tighter monetary policy (including the balance sheet), a dramatic decline in fiscal support (the deficit may be halved this year from 10.8% of GDP in 2021 to around 5.3%), and the higher food and energy prices that sap the purchasing power of consumers will slow the economy. This quarter will likely see better growth than Q1, but starting in H2, a more sustained slowdown may become evident. Interest-rate sensitive sectors, like housing, may already be seeing some evidence.

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The unexpected decline contraction in Q1 US GDP was bit of a statistical fluke. The yawning trade deficit and slower inventory accumulation shaved four percentage points off GDP. Final sales to domestic purchasers, which excludes trade and inventories, rose 3.7% in Q1, which is more than the previous two quarters combined (Q3 21 1.3% and Q4 21 1.7%). The decline in Q1 GDP is not a prelude to a recession and most economists look for a strong rebound in Q2.

Yet don't be mistaken. Growth forecasts are being cut. The World Bank and IMF have cut their global forecasts. This year's forecast for the US was cut to 3.7% from 4.0%, which is still higher than the private sector projection (Bloomberg survey median is 3.2%). Next year, the IMF has the US growing by 2.3% (0.3% less than its estimate in January). This is also a little optimistic compared with private-sector forecasts.

Several European countries, including Germany, France, and Italy cut their 2022 growth outlooks. China's Q1 GDP surprised on the upside, but the details were poor and the full impact of the lockdown in Shanghai (~25 mln people) has yet to be reflected in the data. Indeed, the pandemic in China threats domestic growth and further disruption in global supply chains. The IMF trimmed its forecast for China's 2022 GDP to 4.4% (from 4.8%), while China has targeted growth at 5.5%. 

There were four main developments in the foreign exchange market to note. First, the dollar was broadly stronger, boosted by a dramatic adjustment to the Federal Reserve's now recognized as a hawkish pivot. Second, the divergence of monetary policy drove the yen to 20-year lows against the dollar. The BOJ shows no sign of ending its Yield-Curve Control policy that caps that 10-year yield at 0.25%. Third, the tightening of monetary policy reduced risk appetites, which weighed on the dollar-bloc currencies and Latam currencies. Fourth, the Chinese yuan came under strong selling pressure. The 10-year premium of 100 bp it offered in early March turned into a small discount. Portfolio capital outflows and boosting currency hedge ratios were drags on the currency.

Rising rates and weaker growth are challenging equity investors. Among the G10, only the internationally-heavy FTSE 100 is higher on the year through the end of April. In Europe, Luxembourg (~2.9%), Norway All-Share Index (~6.5), and Portugal All-Share Index (~4.6%) have shined. Between the squeeze on the property and tech sectors and the zero-COVID policy, Chinese equities are among the worst performers through the first third of the year. The CSI 300 (top 300 companies list in either Shanghai or Shenzhen) is off nearly 19% year-to-date. 

A couple of markets in emerging economies are proving resilient in the Asia-Pacific region. The Strait Times of Singapore is up 7.5%, and the Jakarta Composite has risen almost 10%. Most central European equities markets have been sold, but Turkey's BIST 100 Index is up nearly 32% is notable. The lira is off a little more than 10% this year after a 44% decline last year. In 2021, Turkey's shares rallied by about 30%. However, regionally, Latam stands out. Equities in the region have generally rallied amid rising commodities. The nearly 3.5% decline in Mexico's Bolsa is a notable exception. South America and Mexico have accounted for five of the top six emerging market currencies in Q1 22, but in April, as we have noted, there were hit by an aggressive bout of profit-taking. The Mexican peso's's 2.7% decline was the best performer in the region. The Chilean peso lost about 7.26%. The Brazilian real's 4.5% drop trimmed this year's advance to around 12.2%.

UK Prime Minister Johnson's approval suffered before Russia invaded Ukraine, and the war eased the political pressure. However, the issue returned last month as the Prime Minister and Chancellor of the Exchequer were fined by the London police for violating COVID restrictions last year. Chancellor Sunak also ran afoul of poor press as his wife filed taxes as a non-domicile, which means she did not have to pay UK taxes. Sunak had been regarded as a likely candidate to succeed Johnson, but his spring budget statement was poorly received, and the fine for being at a party he denied attending sapped his support. In addition, the Tory showing in the local elections on May 5 (Wales, UK, and Northern Ireland's Assembly) may intensify the pressure on Johnson. Still, there may not be a compelling alternative that could lead the party to victory in 2024.

Germany holds two state elections in May. They may draw interest as a bit of a referendum on the federal government, which has taken at least three measures Merkel did not. First, the controversial Nord Stream 2 pipeline has been formally terminated. Second, After growing increasingly dependent on Russian energy even after the war in Georgia (2008) and the annexation of Crimea (2014), the new German government has set about reversing direction. Third, the SPD-led government committed to boosting military spending after years of under-spending (relative to the commitment to NATO). Schleswig-Holstein's election is on May 8. The state is currently led by a CDU-Green-FDP coalition. North Rhine-Westphalia has a CDU-FDP government, and it goes to the polls on May 15.

Australia's general election is on May 21. It is a close contest. The Liberal-National coalition seeks a fourth term, but voters seem to want a change. However, Labor has run an uninspired campaign. Neither may secure 76 seats in Parliament for a majority. The market anticipates the beginning of what may be an aggressive tightening cycle. An acceleration of Q1 CPI (to 5.1% from 3.5% in Q4 21) with a 4% unemployment rate, spurred speculation of the first move coming at the May 4 central bank meeting, rather than waiting until after the election. The cash rate futures market is discounts about 240 bp of tightening before year-end.

The Bannockburn World Currency Index is a GDP-weighted index of the top 12 economies (recognizing the eurozone as one economy). Half of the constituents are from high-income countries and the other half are from emerging market economies. The index fell almost 2.5% in April, reflecting the decline of the constituent currencies against the US dollar. It was the largest fall since May 2012 and the first monthly decline of more than 2% since January 2015. The