Treasury yields were mixed this week, as the curve flattened by the most in three weeks in the wake of hawkish Fed and ECB meetings. The two-year Treasury yield was 13bp higher on Friday afternoon, leading the front-end weakness, but bond yields were only a couple of basis points lower. However, the USD index weakened, falling 1.2%, pressured by the risk-on move in financial markets.
Stocks fell slightly on Friday but still registered significant gains for the week, as investors focused on tailwinds from disinflation and the new steps by China with regards to economic stimulus. The US CPI in May registered a deceleration in both the headline number and the core CPI figure. Additionally, the PPI in May fell more than expected on a MoM basis.
All in all, beyond the more hawkish message from central banks, the risk-on mood in financial markets is still being driven by two major factors: less signs of financial risk; and ii) the moderation in inflation (despite the still-high levels of core inflation). The recent moderation of inflows into MMF also reflect this improving perception of risk.
Regarding financial conditions, major indices in the US and Europe are back to pre-COVID levels. The decline in implied and realised volatility has also been positive for risk sentiment in rates markets and elsewhere. The reduction in financial risk was even more evident in the banking sector, both in the US and Europe. Our analysis shows that in the absence of systemic risk, easing financial conditions reduce recession risk and support risk assets. This said, for the impact to be sustained financial conditions should remain below the two standard deviation threshold, and this is not the case today.
In terms of inflation, recent data still leave room for optimism about the disinflation process, even in Europe, where progress has been more moderate so far. In our view, this presents an encouraging picture for global inflation (see our comments last week on US and LatAm EM inflation).
Regarding Europe, our analysis also shows that core inflation in Europe will gradually fall further in the first half of 2024. In our view, this evidence will be enough for the ECB to pause in September after hiking again in July, and we believe it is unlikely to raise rates above 4% in this cycle. In our view, the main reason the ECB conveyed a more hawkish message in its conference was to prevent the markets pricing in more rate cuts in 2024 against a backdrop of high macro and inflation uncertainty.
After a first half of the year focused on central bank repricing, elevated bond market volatility and mixed news on the inflation front, we expect a more benign disinflationary outlook going forward, which could still act as a tactical tailwind for the asset class as a whole. The decline in inflation is crucial to the health of households and the consumption outlook. The price shock experienced by European households over the past 18 months has depressed real earnings and caused real retail sales to fall by 4.2% since the peak in 2021.
This said, our risk-reward analysis still favours credit over equity. In terms of European equities, the lack of a significant cyclical rebound suggests that we should still maintain a neutral stance on European assets vs. those in the US.
Actionable idea: The banking sector has been one of the biggest underperformers in 2023 following the recent liquidity crisis, and currently trades at almost a c.30% discount to its long-term PE and at its lows versus the S&P 500. Although deposit risks remain in the sector, we believe that the sector is set to benefit from the recent market rotation from growth into value stocks in the short term, as the market returns to a risk-on state and as the perceived risk in the sector abates.