This year has seen inflation and rising interest rates as the key drivers of bond and equity markets. More aggressive rate hikes in June confirmed that central banks are committed to tackling inflation at the expense of growth. As the month progressed, sentiment shifted away from concerns around inflation and more towards the possibility of a recession. Equity and commodity markets came under pressure, with bonds also falling, but recovering towards the end of the month.

Owing to the scheduled maintenance of the Nord Stream 1 Pipeline and further possible cuts to supply, the expected gas shortages have raised concerns for rationing in the winter months. This fear would weigh heavily across Europe, almost certainly pushing Europe into recession. The US is less susceptible to these supply pressures, having its own domestic production capabilities. Given the 0.75% increase in interest rates seen earlier in June, US data was under close scrutiny to determine the path of future rate hikes. The labour market report showed a robust picture, with hiring continuing at a decent pace and a high level of vacancies. Wage pressures showed some signs of cooling, failing to keep pace with price pressures.

The June CPI data rose to a 40 year high of 9.1%, beating expectations. Energy and food input costs are now feeding through to a wider range of the index components. Overall, this larger than expected increase will not only cement a further 0.75% interest rate increase at the Federal Reserve’s (Fed) meeting on the 27th of July, but we could well see an additional 0.75% at their September meeting. Indeed, some have speculated whether the July meeting will see the Fed join The Bank of Canada in adopting a 1% interest rate increase. As such, the meeting in July will be a vital guide to future hikes. As interest rate expectations hardened, the short end of the yield curve moved to reflect this. However, longer dated bonds began to show the risk that Fed tightening could lead to a recession and as such, the curve inverted.

Acting as widely anticipated by raising rates by 0.25% in June, all eyes await The Bank of England’s (BoE) August meeting. The BoE is expected to announce its intention to reduce the balance sheet with active sales, as opposed to simply stopping the reinvestments of gilts. Furthermore, the hint at the June meeting of “acting forcefully” may indicate that the Bank follows market pricing and raises interest rates by 0.5% in August.

Outside of the markets, the announcement from Boris Johnson that he intends to step down, means that the UK will have a new Prime Minister come September. The following weeks will involve a selection process within the Conservative Party and its members. Regardless of who comes out on top, there is little doubt that the issues of tackling the rising cost of living and energy prices will be at the forefront of the new Prime Minister’s agenda. However, a large fiscal response may prompt increased tightening by the BoE.

Having only recently suspended its bond buying program, the European Central Bank (ECB) is expected to make its first rate rise at its meeting later this month. As unemployment has hit the lowest level since the inception of the single currency, while inflation is at its highest, the ECB is having to move rates up quickly. The ECB’s relatively hawkish guidance has driven Southern European bond yields significantly higher relative to German bond yields. Given that the ECB’s mandate is to set policy for the Eurozone as a whole, this situation is undesirable and may cause solvency concerns over time. Therefore, the ECB is set to announce an ‘anti-fragmentation’ tool in its July meeting to tackle this spread widening. These issues have been exacerbated by domestic politics, with Italian Prime Minister Mario Draghi offering his resignation. Recessionary fears have been more pronounced in Europe given the aforementioned energy crisis.

A straightforward proxy for viewing relative sentiment towards an economy is via the exchange rate. Over the beginning of July, we have seen the Euro (EUR) teetering on parity with the US Dollar (USD) and briefly touching parity for the first time in 20 years, given concerns over higher energy prices weighing on growth prospects. July also saw the first German trade deficit in 31 years due to these rising prices pushing up the cost of imports. Germany’s long-standing and reliable trade surplus has traditionally been a major support for the Euro’s exchange rate, as well as being a significant driver of European economic growth. As we enter the third quarter, central banks will continue to balance the risk of recession with the need to fight inflation. The impact of the war in Ukraine may keep food and energy prices high due to supply-side factors beyond the control of central banks. Elsewhere, falling demand and slowly normalising supply chains in China could ease inflationary pressures, potentially negating the need for further aggressive tightening. With higher interest rates and input costs, investing in companies with strong balance sheets and the ability to pass on price increases will continue to be paramount.

As always, if you would like to discuss your investments then please contact your adviser.

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