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Macroeconomic Outlook: While the Fed Tightens, a Crisis Brews in Europe (Sept 22, 2022)

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By Joel Clark, CEO of KJ Harrison Investors

The world is still working through the ripple effects of the COVID-19 pandemic, even though some political leaders are anxious to declare the fight against the most devastating infectious disease in a century has been won. Yet the nagging truth about today’s interconnected global economy is that the ripple effects of one event or policy tend to run into ripple effects created by other events thousands of miles away. The result is, often, crisis. The rapidly deteriorating economic situation in Europe, along with the impact on currencies and the global economy, provides a case in point – one that investors might do well to pay attention to.

The proximate cause of Europe’s current struggles is the Russia-Ukraine conflict – or, rather, Russia’s response to economic sanctions imposed upon it by the West. President Vladimir Putin has effectively weaponized the fact that Russia is a key supplier of natural gas to Europe, cutting off shipments through the vital Nord Stream 1 pipeline that runs between St. Petersburg and Germany. That has put massive upward pressure on heating and electrical prices for European consumers and businesses, to the point that in some countries energy costs have risen by a factor of seven or even eight.

This is real inflation hurting real people, and it is leading to social turmoil from Great Britain to Italy. Government leaders have, understandably, sought ways to address the brewing crisis, but it’s not as if they can simply turn to other natural gas suppliers (sufficient supply chains do not exist) or immediately create their own supply. So, they are lowering consumer taxes, introducing cash handouts and, in some jurisdictions, capping prices to provide relief from crushing energy bills.

In effect, Europe is printing money – at a time when the world’s most important economy, the United States, is pulling money from the table. On Sept. 20, the U.S. Federal Reserve hiked its benchmark rate by 75 basis points in a move that was widely anticipated by markets after August inflation data came in higher than expected. The stark European-U.S. contrast has not gone unnoticed in currency markets. The Fed’s rate increases and quantitative tightening have created significant tailwinds for the U.S. dollar, and Europe’s fiscal stimulus in response to the energy crisis is making them blow harder. In mid-September, the greenback was stronger against the euro than it had been since the early days of the common currency’s introduction in 2002. Against the British pound, it was stronger than it had been in nearly 40 years.

Some might look at a strong currency as a good thing, but it has two

implications for the global and U.S. economies that are not so sanguine. One is that the greenback is still the reserve currency of the world, meaning many countries borrow in U.S. dollars, meaning a stronger dollar increases their liabilities and sends their currencies diving. It’s not just the euro, although its decline might be the most important. In Japan, which is a significant holder of U.S.-dollar-denominated debt, the yen’s performance against the greenback has been the weakest since the Asian Financial Crisis of the late 1990s, and many emerging market currencies are in similar dire straits. On the plus side, weaker currencies make these regions more competitive on trade; on the negative side, a stronger U.S. dollar makes American companies less competitive – at a time when they are already grappling with the impacts of tighter monetary policy and a slowing economy.

On that note, the Fed might have hoped that the data would have supported it turning less aggressive in September, but inflation in August didn’t comply. Fed officials have been adamant that they will do whatever it takes to contain and reverse rising prices, even at the cost of a recession. The trouble is that inflation data are backward-looking numbers, and as the Fed keeps hiking rates the signs of an impending and severe economic slowdown are becoming impossible to ignore. For some U.S. consumers, mortgage payments have doubled or even tripled over the past six months. For companies, demand is slowing, labour remains tight and energy costs are poised to increase. That will put pressure on margins, and because rates are going up, multiples will come down. And remember that about half of S&P 500 earnings are global – meaning trouble in Europe and elsewhere, as well as a generationally strong dollar, could bite them closer to home. As a result, we see a significant risk of further corporate earnings revisions as we move through this year and into next year.

For now, however, the Fed has given no indication of a ceasefire in its war on inflation. In our view, there is no question it will overshoot – it might have already done so. A recession as a result of monetary tightening looks inevitable, and the odds are greater now that it will be a deep one. Will that be enough to get the Fed to change trajectory? Only four or five months ago, markets had priced in rates falling in early 2023; now, they have pushed cuts to early 2024, effectively discounting higher rates for longer. That is a long way off. Because we see the risk of an economic crisis as higher, more severe and more imminent – perhaps over the next few months – we anticipate the Fed to turn earlier than markets currently expect.

For investors, these conditions and risks support a barbell approach, which informs our firm’s current playbook. For the first time in a long time, credit is more attractive than equities, and investment grade and quasi-investment grade bonds provide an opportunity to play offence and defence. Offensively, coupons are high; defensively, real rates should start to roll over. In equities, our anticipation of that roll-over makes us want to be positioned in the best businesses in the world when the chance comes.

In the meantime, we wait. This bear market is going to test the patience and resolve of investors. There will be rallies, there will be setbacks, and it will take time for the combined impacts of monetary tightening, inflation, COVID-19 lockdowns in China, political unrest in emerging markets, an energy disaster in Europe – there are issues everywhere – to play out. We bear in mind, however, that most market trends break and end with a crisis, and while it is impossible to determine where it will arise, right now all eyes are on Europe.

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