Recession woes continue to bite as inflation concerns retreat

US markets were closed at the start of this week for the Fourth of July holiday; however, the market is still in a frenzy about the prospect of a global economic recession after some worrying signs from the US and German economies. The price of copper, which is considered a lead indicator for a recession, fell another 1.16% on Monday, and is now at its lowest level since January 2021. The sharp selloff in copper has surprised some, and it suggests that market participants think that they are behind the curve when it comes to pricing in recession risk, which could spell more bad news for stocks in the days to come. The markets are awash in contradictions right now: while the copper price is falling sharply and signalling a recession risk, the oil price is rising on the back of tight supply. Added to this, one would assume that if the copper price is falling then so would global bond yields, not so. UK and European bond yields surged on Monday (prices fell), after a steep sell off in bonds last week. We have never seen anything like this in 20-years of analysing financial markets. Below we will try to unpack what’s going on and where prices could go next.

German trade deficit sparks fears for Eurozone

European stocks were a mixed bag with no real direction at the start of this week. UK stocks were higher, on the back of a rising oil price, however, the German Dax index fell 0.3% as Germany reported its first monthly trade deficit figure for 30 years. Surging energy prices pushed up the price of imports, while problems with global supply chains and hold ups for global trade weighed on exports. This caused a $1bn monthly trade deficit in May for the first time since 1991. This is extremely troubling for the Eurozone, if it continues then it could threaten Germany’s position as the financially stable heart of the EU that has driven growth in recent decades. Analysts expect Germany to continue to run a trade deficit over the summer months, however, we think the problem could be more long lasting. The main factor weighing on Berlin’s trade balance is the soaring price of energy, which is unlikely to be resolved any time soon. This highlights how sensitive Germany is to the Russia/ Ukraine conflict and it also casts doubt on the recent growth forecasts for the currency bloc. In the past, Germany has always been able to rely on exports to drag its growth figures higher, however, that is not an option in the current economic environment. Due to this, we could see Germany run a deficit for some years to come, which may lead to difficult economic times ahead for Europe’s largest economy.

Why the Dax could continue to lag its global peers

The euro fell some 0.5% on a broad basis today on the back of the German trade deficit news, however, from a market perspective, we think that traders should look at the Dax and Italian bond yields, as this is where the threat to German growth could do the most damage. German exporters including appliance makers and car manufacturers, are some of the biggest companies on the Dax index. Companies are struggling with two fires burning at the same time: firstly, the soaring price of energy to power factories and secondly, the shortage of skilled workers and materials along with global supply chains that are in tatters. Decimated demand from Russia, and to a lesser extent China are also impacting German corporates. German exports to Russia rose 30% in May compared to April, however, this is still half the level it was a year ago. These dynamics do not bode well for the German economy, which could enter recession this year and drag the rest of the Eurozone down with it. Therefore, we think that the Dax will continue to underperform the FTSE 100 and the US index, as you can see in the chart below.

Chart 1:

German growth fears and Italian bond yields

Elsewhere, Italian 10 -year sovereign bond yields surged 13 basis points on Monday to 3.23%, this increases the spread between Italian and German 10-year yields to 1.9%, uncomfortably close to the 2% level that spells credit stress for Italy. While Italian bond yields jumped on the back of political chaos in Rome, we think that Italian yields could come under more upward pressure if the market thinks that the German fiscal position is deteriorating. Germany has essentially been seen as the financial backstop for the weaker Eurozone economies, if it loses its economic firepower then the risk premium for Southern European sovereign debt must rise.

Why Treasury yields could rise alongside recession risk in the short term

Elsewhere, it is worth noting that while US 10-year yields fell more than 30 basis points last week, we expect them to rise on Tuesday. This is not because the market is considering recession risk in the US less of a threat, but because the bond market moved too far too fast in 3-days last week, thus some recalibration is to be expected. Added to this, we will get some key Fed speakers this week, if they sound more concerned about inflation than growth, expect more fireworks in the global bond markets. Recession risks are flashing for the US economy, including the ISM manufacturing survey for June. This was released on Friday and fell sharply to 53%, from 56.1% in May. While this is still in expansion territory, the pace of the decline is alarming and if it continues then the ISM surveys could be pointing to contraction territory in the next few months. New orders fell below 50 in June, the employment index also contracted sharply, and the inventories index rose a notch to 56%. This does not bode well for the US manufacturing sector, which tends to be a leading economic indicator. It also suggests that the US labour market could be in for a slowdown, although we will look at this in more detail later in the week. The bright spot in an otherwise dreary survey was inflation, the prices index fell more than 3% last month.

US inflation expectations retreat

This leads us to another interesting observation, US inflation expectations, as measured by the 5-year 5-year forward Treasury yield, is at its lowest level since February, at 2.08%. Thus, inflation expectations are almost back at the Fed’s target rate. So, we will be watching to see if the Fed speakers, including uber hawk James Bullard, sounds less worried about prices this week.

For now, a rising dollar is a sign of weaker risk sentiment. We think that the bias for US stocks is lower, particularly if Bullard and co are hawkish. This week’s payrolls could change things, and we may see the theme of “bad economic news is good news” for risky assets come back into play.