Prospects for the new semester: ‘butter or cannons’

The outlook for the second half of 2022 is shrouded in a high degree of uncertainty. This statement seems like a cliché in this type of column, but in this case it is not. The outcome of Russia’s invasion of Ukraine is not easy to predict and whatever that outcome will have very drastic consequences in one way or another.

The market has discounted the fact that the war will be dilated in time, but concentrated in space; From this we can deduce that a quick and satisfactory solution would be good news, now not discounted, and that a geographical extension, although possible, is ruled out and if it occurs it would sink the risk asset markets.

The prolongation of this warlike conflict supposes, from the economic point of view, less growth and more inflation. And once resolved, it will also mean less economic well-being, because a higher percentage of GDP will have to be allocated to military spending, and more inflation, since less capacity will be allocated to consumer goods; let’s remember the famous phrase butter or cannons attributed to Nobel Prize winner Paul Samuelson.

Inflation is at a high level. Despite the fact that there have been brutal fiscal and monetary expansions, the origin is basically on the supply side, as a consequence of lower production after the pandemic. In addition, the bottlenecks are proving to be more persistent than expected and a very poorly planned energy transition, which has had an impact on the rise in fuel prices, has finished off the situation.

All these problems have also been aggravated by Russia’s invasion of Ukraine, since these are two large producers of raw materials globally. Without prejudice to the validity of the previous analysis, it should be noted that inflation has many more elements of demand in the United States than in Europe, since in the former the labor market is in an extremely tense situation.

It is true that central banks cannot do much against supply-side inflation, but they can prevent second-round effects and anchor the inflation outlook in the medium and long term. Furthermore, although it is still a bit rash to say so, we are beginning to see signs that the bottleneck they reached their peak at the time of the closing of 2021 and are giving way in 2022, also here again more on the other side of the Atlantic than on this.

It is clear that the central banks have reacted with measures against the increase in inflation to prevent it from becoming chronic. Europe has already abandoned the unknown land of negative rates, raising its reference rates by 0.5%, and the Fed has placed them at 2.5%.

It is advisable to carry out a sufficiently retrospective analysis to put the current situation in its proper dimension. Since the Great Financial Crisis we have experienced an unusually low interest rate situation. In addition, since the beginning of the 1980s, the profitability of public debt began a downward path (rising in bond prices) that has practically continued to this day.

From this analysis we deduce that, despite the recent rises, central banks’ key rates are in an unusually low situation, very low, compared to history and also in view of current levels of inflation.. We do not expect excessive increases, since the issuing banks are aware that there are not many other ways to solve the problem of the viability of the very high public debt than fiscal repression (Treasury bond yields below inflation). In short, there is still room for a rate hike and, despite what appears to be the contrary, it would allow higher growth rates in the long term, despite the penalty in the short term. The reason is that it would cleanse the economy of companies zombie, which are a drag on productivity because they absorb resources that would be much more productive in another activity. Forecasts place these guiding rates at around 1.5% in Europe and 3.5% in the United States at the end of 2022.

In its forecasts announced in April, the IMF is projecting growth of 3.6% in both 2022 and 2023, but with a clear contrast between the two years, because in 2023 the expansion will weaken in developed countries and that gap will be covered by emerging However, the shadow of the recession in developed countries in an environment of interest rate hikes is a threat that we cannot rule out and that is not included in these forecasts.

The perspectives for the markets will be determined in the first place by the evolution not only of the war in Ukraine but also by the economic measures taken by the parties involved and their effectiveness, these parties being not only the declared ones, Russia and Ukraine, but also the undeclared, as is the case with the EU countries.

We think that the current levels of government bonds are not yet attractive. They do seem so, however, corporate debt spreads, both in their investment grade tranches and high-yield; however, the latter must be viewed with caution if a recession is finally triggered. Equities have had a significant setback and seem to have corrected previous valuation excesses, but a possible recession would drag a downward revision of profits that analysts have not yet reflected in their forecasts. We have no doubt that they are attractive in the long term, but it is difficult to think at this time that the punishment of the actions is over.

And, finally, at these levels we would be more buyers of euros than dollars; the market has priced in a highly penalizing exchange rate for the euro, which can only be understood if everything in Europe continues to go wrong.

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Prospects for the new semester: ‘butter or cannons’