Despite facing 500 basis points of Federal Reserve rate hikes, the broader US economy has demonstrated resilience and reaccelerated to its trend in the first half of the year. However, the situation in Europe tells a different story, as growth has been disappointing. The European Central Bank’s tightening approach suggests that eurozone growth for 2023 is likely to be weaker compared to 2022.
By Olivier De Larouzière, Chief Investment Officer for Global Fixed Income, and Daniel Morris, Chief Market Strategist, BNP Paribas Asset Management.
China also faces challenges with its reopening, resulting in GDP growth below trend and the risk of deflation. Stubborn services inflation has hindered central banks from adopting an easier policy stance, despite the effects of base and energy factors lowering headline inflation rates. While concerns over regional banks have diminished, the US policy rates are expected to rise further as the Federal Reserve maintains its hiking bias, albeit at a slower pace.
Similarly, the ECB’s President Lagarde emphasizes the need for more work, and all major central banks seem poised to raise rates higher than initially anticipated. The ultimate question remains about the peak of policy rates, but the path indicates continued tightening by central banks worldwide.
In this quarter’s Global Fixed Income Outlook, Olivier De Larouzière and Daniel Morris observe how market narratives have been shifting rapidly across the US, Eurozone and the UK.
US
Despite the resilience of the US economy, there are reasons for caution. Regional banks face rising funding costs that will impact earnings and limit their ability to provide credit to small businesses and commercial real estate.
The economy has been supported by strong household spending and legislation encouraging business investment, but Treasury tax receipts and business confidence surveys have slowed.
The housing sector has shown resilience to higher mortgage rates, and the labor market remains robust, but signs of easing strain are apparent. Inflation remains a concern, with shelter costs showing moderation, but non-shelter services continue to be a focus for the Fed.
The MBS sector has performed well, driven by investor demand and limited supply, but challenges remain. Overall, monitoring credit conditions and inflation will be crucial for both investors and policymakers, determining the trajectory of the Fed’s tightening cycle.
- OUTLOOK: Economic data continues to paint a mixed picture, which both limits our conviction and leads to rapid shifts in market narratives. However, everything pivots around the answers to two key questions:
- Is labour market rebalancing possible without a significant rise in the unemployment rate?
- Is the US economy proving to be less responsive to monetary tightening than anticipated?
- To the first question, we acknowledge that wage gains and other signs of labour market strain have eased over the last year, without the unemployment rate having risen. On the second question, the answer has to be ‘yes’. The Fed has tightened monetary policy at a rate unprecedented since the early 1980s.
Eurozone
The eurozone is experiencing a mild contraction, but it demonstrates resilience despite challenges like an energy shock, high inflation, and tightening monetary policy.
Looking ahead, the energy shock’s impact is expected to ease with declining energy prices and ample natural gas storage, contributing to inflation moderation amid a strong labor market.
However, the manufacturing sector remains weak, and the services sector’s growth appears to be waning. While underlying price pressures show early signs of leveling off, the ‘supercore’ and domestic inflation indicators continue to rise, indicating persistent domestic price measures even as energy shock and supply chain pressures recede.
- OUTLOOK: We expect growth to stagnate over the next few quarters after significant monetary policy tightening and the rolling back of fiscal support. Yet, the mild slowdown in demand is unlikely to cause a significant increase in unemployment as structural factors such as demographics and sectoral mismatch will likely keep the labour market tight. This, alongside sticky core inflation, suggests that the ECB will maintain a hawkish bias until more evidence of sustained disinflation emerges.
UK
Headline inflation is projected to decrease significantly, influenced by declining energy prices and a likely further reduction in utility bills in October. While food inflation may have reached its peak, the decline is expected to be gradual.
Core goods prices are also likely to decrease due to falling wholesale costs, while core services inflation may take time to recede due to wage adjustments after ongoing strikes.
Surprisingly, inflation expectations from business and consumer surveys have fallen despite increased realized core inflation, indicating lower risks of a wage-price spiral.
However, strong wage growth and a slow labor market easing suggest that the Bank of England will likely need to raise rates further to combat inflation effectively.
- OUTLOOK: Wage growth will likely remain strong in the near future, but moderate through the second half of the year as the labour market continues to loosen. The long-awaited loosening in policy before the next general election is unlikely to materialise in the near future. We see a 50bp move in August followed by a further 25bp hike in September, taking the bank rate to 5.75%. Further ahead, we believe the BoE could under-deliver versus the 6.2% terminal rate priced by markets at the end of June
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