Each week, we present our featured topics in the context of major themes from Nuveen’s most recent global investment outlook:Opens in a new window
- U.S. economy: Recession has become a 50/50 proposition by the end of next year.
- Global economy: High commodity prices threaten emerging markets and energy importers.
- Policy watch: Central banks are tightening but now risk going too fast, too far.
- Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
- Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
- Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.
Quote of the week:
"The dollar may be our currency, but it’s your problem.” – John Connally, former U.S. Treasury Secretary
Commodities and the U.S. dollar: strange bedfellows this year
Nearly 50 years after the band Chicago scored a Top 10 hit with “Feelin’ Stronger Every Day,” the tune serves as a perfect theme song for the U.S. dollar, which has surged 10.6% from the start of the year through its peak on July 14.4
What’s been fueling the greenback’s gains in 2022?
- An aggressively hawkish Federal Reserve, whose outsized rate hikes have helped drive up U.S. Treasury yields. This in turn attracts capital from overseas investors seeking more attractive income from their bond holdings. These investors must convert their local currency into U.S. dollars to buy dollar-denominated assets. This increased demand for the dollar bolsters its value.
- Russia’s invasion of Ukraine, which sent commodity prices and general market volatility higher, creating uncertainty in Europe. When investors become fearful, demand rises for safe-haven assets like the dollar and U.S. Treasuries.
- Greater odds of a recession, driven by weakening economic data worldwide. Worries abroad often translate to a “flight to quality,” benefiting the buck and U.S. government securities.
Interestingly, for most of this year, the U.S. dollar and commodity prices have been positively correlated — that is, they’ve moved in the same direction. This is not normal. Historically, they’ve had an inverse relationship: when the dollar rises, commodity prices fall, and vice versa. That’s because commodities are priced in U.S. dollars but traded globally.
What’s made 2022 different is the sharp reduction in the supply of numerous energy and agricultural commodities such as natural gas, wheat and coal. Shortages in these key areas have been driven in large part by Russia’s invasion of Ukraine, starting in late February and resulting in far higher prices for these items even as the dollar was “flexing its muscles.”
The best predictor of short-term movements in exchange rates is usually short-term changes in real (i.e., after inflation) interest rates. When one country — the U.S., in this case — is experiencing a big increase in real interest rates while another (Germany, for example) is not, that tends to push the dollar higher against the euro, which is precisely what’s happened recently. Indeed, the euro has come closer to achieving parity with the dollar than at any time since 2002.5 (Parity means one euro equals one dollar.)
Looking further ahead, it’s clear that 2022’s market conditions, punctuated by white-hot inflation, hawkish central banks and rising energy prices, have been bad for risk assets but positive for the dollar. In our view, a continuation of this environment could push the dollar even higher over the next six to 18 months, especially if inflation forces the Fed to keep hiking rates. This means we’ll hear more in the coming quarters from U.S. companies blaming dollar strength for soft revenue growth, as their exports become less competitive in overseas markets. The flip side, though, is that U.S. consumers will benefit from cheaper imports, especially if commodity prices continue their recent decline.
Central banks go for the element of surprises over steady guidance on future moves
Last month, the Federal Reserve surprised markets with a larger-than-expected 75 basis point (bps) rate hike. Then, on July 13, Canada’s central bank tightened by 100 bps rather than the 75 bps anticipated. And to top it off, this past Thursday the European Central Bank (ECB) scrapped its June guidance, which had called for a 25 bps rise, and hiked rates by 50 bps.
The ECB’s extra 25 bps of tightening doesn’t change Europe’s inflation outlook and should have no lasting market impact if it simply reflects a front-loaded approach to reaching a desired ending, or terminal, rate level. Indeed, investors were mostly unfazed, and unimpressed, by the ECB’s move.
What will matter for European equity markets over the next several months is whether the ECB is able, through a cumulative increase in rates over its coming meetings, to lower core inflation without triggering a recession. With the looming threat of sharply higher gas prices hanging over consumers’ heads, this will be a daunting task, to say the least. (Core inflation, unlike the headline number, strips out food and energy costs.)
Overall, central banks’ discarding of credible forward guidance in favor of “surprises” seems driven by their desire to appear tough on inflation. But the magnitude of a rate hike at any given meeting is of relatively little importance to economies or markets – something that central bankers haven’t yet grasped, it seems.
The next major central bank gathering will take place this Wednesday, July 27, when the Fed meets again. Despite some bobbing and weaving amid headline noise, market expectations have been fairly consistent in pricing in another 75 bps increase, topped off by a few more hikes over the course of the year, until the target fed funds rate peaks at around 3.50%. Last week, investors flirted with the possibility of a 100 bps increase after June’s decades-high CPI print set off inflation alarm bells, but the Fed hasn’t endorsed such an outsized move, nor has the preponderance of economic and market data called for it.
In our view, Chair Jerome Powell and his colleagues are unlikely to slow or stop their rate increases unless and until they come to believe that inflation is easing to a more acceptable rate, one far closer to the Fed’s 2% target.
Did the U.S. enter recession this year?
We’ll find out this Thursday, when second-quarter GDP data is released. A decline in annualized economic growth, if it occurs, would mark two straight quarters of contraction, meeting the generally accepted definition of a recession. But a recession in which real demand grew and unemployment fell (both of which happened in the first and second quarters) would be highly unusual. Still, every recession is different from any that preceded it, as we found out in 2020, when Covid lockdowns shuttered businesses and many people remained at home.
Recessions, when they occur, are almost always the result of falling demand. One fact that will stand out should the economy now prove to be contracting again: the cause will largely be a lack of supply. Simply put, some sectors of the U.S. economy haven’t been able to produce enough of the “stuff” Americans want to buy, including rental properties. Moreover, other segments needed to reduce their bloated inventories before they were willing to produce more. The key factor to watch in Thursday’s release will be whether domestic sales rose. This gauge of private sector demand is typically the most reliable indicator of not just where the economy is today but where it will end up tomorrow.