Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
The inflation conundrum and private equity party
Peter Garnry
Chief Investment Strategist
Key points
- The ECB faces a conundrum with upcoming rate cuts, needing to act decisively following other central banks' recent cuts, while concerns rise about potential policy mistakes if inflation data surprises on the upside.
- Despite high interest rates, the Eurozone economy is showing signs of growth, driven by factors such as a tight labour market, strong commodity markets, and geopolitical pressures, which could lead to a dangerous mix for inflation.
- Private equity is thriving even with high interest rates, with listed private equity showing strong performance, notably led by British 3i Group and its successful investment in the retailer Action, highlighting the sector's resilience and potential for high returns.
The inflation conundrum persists as ECB doubles down on rate cut
The upside surprise to UK inflation last week pushed the first BOE rate cut from August to November while the ECB expectation sat firm at June. ECB has increasingly talked itself into a corner where it must deliver or look foolish, but will the central bank look foolish regardless? The ECB chief economist Philip Lane is telling the Financial Times that the ECB sees no issues with moving before the Fed on rate cuts and the data points have caused the ECB to remove the top level of restrictions. When the ECB moves next month it will follow recent central bank cuts from Switzerland, Sweden, Czech Republic, and Hungary. On Wednesday, the May preliminary German CPI figures are released and in the case we see another upside surprise the question that will come to mind is whether the ECB is about to make a policy mistake.
The ZEW survey recently surprised to the upside hitting 47 which significantly above the average of 19 the past 10 years suggesting the sentiment on the Eurozone economy is getting stronger and stronger. The fact that the Eurozone economy is bouncing back into growth despite what the ECB sees as restrictive policy rates should tell the ECB that the high interest rates were not the causality driving the mild recession, but instead the short-lived shock the war in Ukraine colliding with the effects from inflation.
Wages have not cooled a lot in the Eurozone and the demographics mean that labour market could remain much tighter for much longer than what the ECB is expecting. Combining this with stronger commodity markets and the rebound in the economy and you have a potential dangerous cocktail for inflation if the ECB is also loosening financial conditions. To top it all, the geopolitics will add to inflationary pressures through two channels:
- European finance ministers called G7 nations on Friday to stay united on the view that China is undermining market based economies with their trade practices. As we have said for some time. The harder China pushes on the export string to resolve their economic problems the bigger the pushback will be leading to tariffs and more reshoring of manufacturing pushing up goods inflation over time.
- The war in Ukraine and the wider conflict with Russia will push EU countries to go beyond the fiscal constraints to ramp up military spending without sacrificing general welfare spending. This will be inflationary as it increases the investment rate in Europe and drives up demand for workers and raw materials.
Private equity is the thriving despite elevated interest rates
Last week’s surprise upside to UK inflation and repricing of monetary policy delivered a blow to bond markets declining across the board. The biggest casualties however were real estate and gold declining 2.6% and 2.9% respectively. Emerging market equities also did not like this outlook of high interest rates for longer declining 1.5%.
The top performing asset class was listed private equity up 1.3% extending the year-to-date performance to 14.6% only surpassed by gold. Private equity has historically been thriving on low interest rates and as such one would have believed that high interest rates would be bad for private equity. But as the one-year performance shows, private equity has been the best performing asset class over the past year up 51.4%.
The biggest constituent in the listed private equity index is British 3i Group which reported results earlier this month highlighting strong performance with its portfolio company Action delivering strong annual growth of 28% and like-for-like growth of 17% which quite impressive for an European retailer. Action is the fastest growing non-food discounter in Europe with more than 2,300 stores and €8bn in revenue. We highlighting 3i Group and its investment in Action, because it can sometimes be difficult to understand what investors are actually getting exposure to when investing in listed private equity. But essentially, investors are getting exposure to companies in various industries and the bet the investor is taking is that these private equity firms are able to deliver a return that is higher than that in public markets.
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