Stagflation and increased volatility in Europe and the US. Report by Filippo Casagrande

What will happen to the economies of Europe and the United States? The analysis by Filippo Casagrande, Head of Insurance Investment Solutions at Generali Asset & Wealth Management.

Stagflation reflects in one word the current complicated economic situation: on the one hand, inflation remains at very high levels, even setting new highs. On the other hand, growth estimates for both 2022 and 2023 continue to be revised downwards. To aggravate the picture the crisis of supplies and energy prices for the near future, especially in Europe. It is clear to all how we are in a period in which the combination of geopolitical tensions, primarily the conflict in Ukraine, and the limitations of resources once considered abundant (such as energy, but also cheap labor) are undermining the models of economic policies adopted in the last decade. At the same time, the high levels of public indebtedness achieved in most advanced countries and some developing countries place limits on the ability to react to future economic shocks. Increased geopolitical uncertainty and the limits placed on monetary and fiscal policies can only result in increased volatility in business cycles, and consequently greater volatility in financial markets. This new scenario requires a greater capacity for analysis than in the recent past and an even more attentive approach to investing and portfolio construction. The numbers of inflation Inflation data have not been encouraging over the past month, surprising once again on the upside. In the United States, headline inflation hit +9.1% year-on-year in June, up from 8.6% in May and above analysts' estimates (+8.8%). This is the highest level since November 1981. To push up further the growth of prices were the increases in the energy component (+41.6% year / year) and food, which with their component of food for domestic use mark a + 12.2% year / year (they were +0.7% in May 2021), the largest increase since the spring of 1979. If the food and energy components mark new highs, the "core" component marks a slowdown, albeit marginal, from +6.0% in May to +5.9% in June. The figure, however, surprised on the upside compared to analysts' estimates (+5.7%) and its internal composition shows dynamics that are not very reassuring. Those factors repeatedly cited by the Fed during 2021 to indicate as "temporary" the rise in prices (for example used cars, hotel prices) mark a significant slowdown, going from +20.1% in February to the current +8.2%. Inflationary dynamics are also worrying investors in the Eurozone. Headline inflation in June was up 8.6% year-on-year, a new record after the already high +8.1% recorded in May. It should also be remembered that this figure benefits from government interventions to calm energy prices. The impact of these interventions at European level is estimated at a reduction of half a percentage point in the inflation rate in May (latest available data), but countries such as Italy (-1.3%) and Spain (-0.9%) have taken particularly incisive measures. More recently, some countries have announced other measures to calm price growth, including Germany and Spain, which have launched plans to significantly reduce public transport prices in order to alleviate the impact of rising fuels. And thanks to the measures taken in Germany (public transport at 9 euros / month from June to August), core inflation has slowed slightly, from + 3.8% in May to + 3.7% in June. Despite the slight decline, the level of core inflation remains almost double the ECB's target, reflecting the strength of the labour market in Europe as well, with the unemployment rate falling to 6.6% in May, the lowest level since the birth of the euro. Looking at the average annual forecasts, the bull run in consensus estimates continues. According to Bloomberg data, the estimate of average inflation for 2022 in the United States has reached 7.9% (from 7.1% at the end of May and 4.4% at the beginning of the year). In the Eurozone, the estimate rose to 7.5% from 6.8% at the end of May (and 2.45% at the beginning of the year). Estimates for 2023 also rise, reaching 3.6% respectively in the United States and 3.4% in the Eurozone (seven tenths more than the levels at the end of May). Growing clouds over growth In the last month the deterioration of growth estimates has been particularly marked and there is talk of a recession in the coming quarters. According to the data collected, GDP growth estimates for 2022 in the United States fell from 3.9% at the end of 2021 to the current +2.1%, while those for 2023 fell from 2.5% to 1.3% (a drop of 7 tenths in a single month). Similar dynamics in the Eurozone, with estimates for 2022 cut from 4.2% to 2.7% and those for 2023 from 2.50% to 1.35% (again minus 7 tenths in the last month). The labour market is also showing some signs of slowing down, although at the moment the signals between the different surveys are mixed. The most indicative sign of a slowdown comes from the confidence indicators of manufacturing and services companies, with the Employment index of the ISM surveys falling to 47.3 (manufacturing) and 47.4 (services), well below the 50 level which historically indicates a contraction. In Europe, to these dynamics common to the United States, are added the risks posed by energy supplies. In the last month the scenario has worsened considerably. First, an explosion at the gas liquefaction plants in Texas, a hub for Liquified Natural Gas (LNG) exports to Europe, greatly reduced the prospects for flows from the United States. In the days immediately following, the Russian company Gazprom announced a progressive reduction of flows to Europe, up to a complete interruption of flows via the Nord Stream 1 pipeline, due to the need to replace a turbine. While Canada has given the green light to deliver the turbine to Russia, there is extreme uncertainty about an effective resumption of flows to Europe, with Gazprom announcing on Monday (July 18) the indefinite stop of flows to Germany due to force majeure. Gas prices delivered in Europe in December 2022 rose by almost 90% in the last month, reaching a price ten times higher than the prevailing levels in the period 2017-2020. Monetary policies After the sharp upward revisions in interest rate hike expectations in the first half of June following above-expected US inflation data and the less dovish communication from the ECB and the Fed, we have seen a divergence between central bank statements and market movements over the past month. Investors have, in fact, begun to price in the impact of a possible recession on central banks' ability to hike, anticipating the Fed's rate spike from the first half of 2023 to the end of 2022 and beginning to price in rate cuts during 2023. Also for the ECB, the estimates of rate hikes, which rose to 2.50% by the end of 2023, have been reduced, and now see a Euribor rate at 1.25% at the end of 2022 and 1.65% at the end of 2023. Financial markets and prospects We must get used to a world marked by structurally higher volatilities, both in socio-economic terms and in the financial sphere. The last six weeks in the bond world have been marked by exceptional levels of volatility. The European Investment Grade Bond Index (government and corporate aggregates) experienced realized volatility of more than 10% annualized, four times the norm of the last 20 years. The volatility achieved during the weeks of the first Covid wave, the previous all-time high since the birth of the euro, has even been overcome. Even in the US, volatility in the bond world is exceptionally high. Implied volatility on Treasury stocks has recently peaked at March 2020, and you have to go back to the Great Financial Crisis of 2008/09 to find higher values. After heavy losses in the first two weeks of June, developed country government bonds rebounded significantly, with sharp declines in yields, which followed lowered expectations of central bank policy rates. The yield on 10-year German Bunds, after touching 1.90%, fell back to the 1.20% area. The Investment Grade credit market has benefited from this decline in yields, although there has been a further moderate widening of spreads. On the other hand, the underperformance of the High Yield sector is net, whose spread in Europe has largely exceeded 600 basis points, the highest levels since April 2020. As for equity markets, there was an attempt to rebound, more marked in the United States, while the Eurozone fell slightly due to fears about energy supplies and renewed fears about China (uncertainties in the housing mortgage market). However, the most significant factor in equities in the last month has been the strong outperformance of the Growth segment (+5.5% since mid-June) compared to the Value segment (-4.1%), particularly in Europe. Leading this movement, the collapse of Basic Resources, Energy and Banks, until a month ago among the best sectors on European lists. Those sectors have suffered on the prospects of a closer recession and the combined decline in rates and commodities, which have left two-thirds of year-to-date gains on the ground. Looking ahead, we reiterate the scenario of greater volatility and uncertainty, which unlike past episodes, involves the bond world to a greater extent and (at least until now) to a lesser extent the equity world. Uncertainty about economic dynamics and the precarious balance between the need for restrictive monetary policies to combat inflation on the one hand, and fears of a recession on the other, are issues that we will continue throughout the year. Seek exposure to alternative liquid strategies : the current uncertainty of the macro scenario favors alternative strategies that are able to benefit from different scenarios with a highly active approach (long short, event drive, etc.) in particular to favor discretionary and systematic macro strategies and low correlation strategies. With regard to private asset investments, considering the illiquidity premium and risk-adjusted returns, we believe that the trend of gradual allocation to private markets will continue to benefit from the ability to employ capital at better valuations, but it will be important to focus on defensive strategies such as senior lending and secured lending, looking carefully at so-called " distressed strategies". ". 24 July 2022