Stocks stare down central bankers

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes from Nuveen’s most recent global investment outlookOpens 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:

"When life seems hard, the courageous do not lie down and accept defeat. Instead, they are all the more determined to struggle for a better future."  –  Queen Elizabeth II

Europe enters a challenging period of “dueling” policies

After raising interest rates by 50 basis points (bps) in July in an initial bid to tame inflation, the European Central Bank (ECB) hiked rates by 75 bps last Thursday, a move that raised few eyebrows even as it marked the ECB’s biggest single-meeting increase in borrowing costs.⁴ With eurozone inflation heating up to 9.1% (year over year) in August, ECB President Christine Lagarde stated in her post-meeting press conference that “we have to take action.”⁵

How much more “action” is in store from the ECB to achieve its 2% inflation target? Without providing specifics about the magnitude of any further hikes, Lagarde acknowledged that doing so “will take several meetings,” which she defined as “more than two” — not counting last week’s — “but probably less than five.”

Though monetary policy is tightening across the Atlantic, fiscal policy is expanding. For example:

• In Germany, workers who pay income tax will receive a one-off energy price allowance to supplement their salaries. Additionally, families will receive stimulus checks and credits to pay for rising gas prices.
• Britain's new prime minister, Liz Truss, announced a plan to cap consumer energy bills for two years.
• France has committed to limit increases in regulated electricity costs. To help do this, the government has ordered utility company EDF, which is primarily state owned, to sell more cheap nuclear power to rivals.

We harbor some concerns that competing central bank/government policies will prevent a severe recession in Europe. Consumers and businesses might crack under the simultaneous pressure from higher interest rates and soaring energy costs. That said, it’s possible that fiscal largesse could help keep Europe’s economies afloat until energy costs begin to fall. Balancing these considerations will be no easy task.

Elsewhere in the world, China has once again locked down a number of its cities and provinces in an effort to contain a new outbreak of COVID-19. These draconian measures are less important to the global economy in 2022 than they were in previous years, because China’s role as an export powerhouse has diminished. Indeed, its export growth fell sharply in August, as the country’s trading partners eschewed Chinese manufactured goods, focusing instead on “home grown” services such as dining out.⁶ During prior lockdowns and other times of economic stress, China has prioritized the health of its export-sensitive sectors, particularly by devaluing its currency. That makes its products more competitive in overseas markets. But micromanaging industrial policy is of little use if customers no longer want (as much of) what you’re selling.

But the troubling news doesn’t end there. China has a domestic demand problem, as well. Imports have barely budged over the past year. This week, a slew of data, including retail sales and industrial production, will be released, potentially confirming the downshift in activity. One likely culprit for the decline: the effect of China’s “zero COVID” measures and their unpredictable nature. Chinese households may be increasing their savings in order to have more cash socked away should they be unable to work due to lockdowns at some point in the future.

With both China and Europe struggling, it's no wonder investors continue to covet safe haven assets like the U.S. dollar, even as the greenback continues to move ever higher against nearly all other currencies. A hawkish Federal Reserve, relative economic resilience and a perceived lack of investment alternatives are all helping the dollar close in on its highest trade-weighted value in decades.⁷

The U.S. economy soldiers on

While other central banks are playing “catchup” in their bid to quash inflation, the Fed has already taken some bold steps, with 75 bps hikes in June and July. Despite the headwinds provided by this tighter policy, the U.S. economy appears to be weathering the new higher-rate environment surprisingly well. Consumers are still spending, businesses continue to hire and prices are dropping on a growing number of goods. (We’ll find out just how many on Tuesday, when August’s Consumer Price Index inflation will be released.)

Investors in risk assets like equities and corporate credit are still struggling, though. But what allows the Fed to remain singularly focused on inflation —resilient consumers and strong hiring demand, especially — are also supporting those markets despite their negative returns for the year to date. While a fed funds rate of 4% by year-end as projected by traders —up from its current range of 2.25%-2.50% — might thwart hopes of a bull market, such an increase would occur in the context of a solid U.S. economic backdrop, one in which earnings wobble but are unlikely to collapse, credit downgrades should be manageable and defaults remain rare. A year or so of elevated interest rates and subpar economic growth is not the worst outcome, especially with investors now able to lock in high yields across the fixed income spectrum.