There are three main challenges that markets face: inflation, US rates and the US dollar. Analysis by Colin Graham, Head of Multi-Asset Strategies at Robeco
Global growth will not regain momentum until recent price hikes and rate hikes used to counter them have reached their zenith. Only then will the US dollar, whose strengthening has pushed up the cost of foreign trade and put pressure on emerging economies, begin to weaken. Just like the UK's famous Three Peaks Challenge, where runners must reach the tops of the highest mountains in Scotland, England and Wales within a set timeframe, all three economic peaks will need to be overcome in the second half of 2022 for markets to stabilise. The Three Peaks Challenge, #1: Inflation The first peak to be conquered is inflation, which has accelerated due to the substantial increases in energy and food prices after the end of the Covid-19 pandemic and as a result of the Russia-Ukraine war. In the United States and the eurozone, inflation reached 8.6%, the highest level since 1981, and 8.1%, the highest value ever, respectively. Before the pandemic, inflation had remained steadily below 2% for many years. "Inflation has been a favorable indicator for investors for over four decades, since Paul Volcker, the then chairman of the Federal Reserve, brought U.S. inflation back under control, then at 20 percent, and restored the central bank's credibility in the early '80s. We know that central banks have the tools to contain inflation by raising interest rates; this reduces credit creation (ending easy money) and cools the housing market (borrowing mortgages for liquidity purposes), two developments that weaken aggregate demand and increase unemployment. A slowdown in the economy will be instrumental in reaching peak inflation, although we are aware that, as interest rates are a blunt tool, investors will find themselves swinging wildly between the fear of excessive tightening, which could cause a recession, and that of insufficient tightening. The picture is therefore destined to remain volatile. Inflation is mostly visible in rising retail prices, but it is also detrimental to the stock and bond markets. Inflation erodes the profits of firms that fail to pass on cost increases to prices and reduces the value of long-term bonds. Energy price increases affect the entire economy, penalizing both businesses and consumers, acting as a growth tax and reducing demand for services and other goods. In addition, increased uncertainty about corporate earnings and companies' ability to preserve margins by shifting input cost increases (including labor and debt costs) to prices is set to fuel volatility in equities and high yield stocks. The fact that the Fed has stopped using only Core PCE (excluding energy and food) as a preferred measure of headline inflation indicates that inflation could finally peak in the third quarter of 2022. The Three Peaks Challenge, #2: U.S. Rates The next mountain to climb is that of interest rates, which have been raised around the world to combat inflation. As rates rise, borrowing becomes more expensive and consumers have less money to spend. The rate hike, however, also has side effects, including the further appreciation of the already expensive US dollar. The US Fed Funds rate is projected to rise to around 3.5% from 1.75% at the end of June, which would be the largest rate hike in a calendar year since 1980. In 1994, when what is generally considered a 'soft landing' was recorded, US rates jumped to 2.5%. Therefore, the tightening cycle today is more difficult, because the economy needs a similar reaction. In our view, spikes in inflation data will indicate a decline in inflationary pressures, signaling that rate hikes are having an effect on the economy. In the second half of the year, we expect potentially more favourable financial conditions: rate expectations are expected to decline and the fed funds target rate may not reach 3.75%, as implicitly predicted by the market, by the end of the year. All other things being equal, this consensus would imply an inversion of the yield curve, with increasing alignment and more conclusive signals from recession indicators. In our baseline scenario, we do not expect a US recession in the next 12 months, although China, Japan and Europe may not shy away from this fate. The Three Peaks Challenge, #3: US Dollar The third challenge is the US dollar, which has reached a twenty-year high against the world's major currencies. Traditionally considered a safe haven asset in difficult times, the appreciation of the greenback increases the cost of dollar-quoted commodities. This in turn negatively impacts emerging markets that rely on commodity exports and need dollar financing. Once expectations about US interest rates and inflation have peaked, we can expect the US dollar to do the same. We don't know for sure if this will happen before, during, or after the other two peaks. But it is important to monitor the performance of the US currency, which arouses the interest of a very heterogeneous range of traders and holders not oriented towards profit maximization. At the moment, the main drivers of the greenback – namely interest differentials, growth differentials and capital flows directed towards ' safe haven assets' – are positive. As growth slows and interest rate expectations fall, the onerous US dollar is expected to weaken.