2022 is proving to be a very difficult year for investors as most asset classes are performing negatively due to fears of an economic slowdown that could force some of the world’s largest economies into a recession. In fact, the S&P 500 index in the US just missed dropping into ‘bear market’ territory last week following a brief rally last Friday. By close of business last Thursday, the main equity benchmark in the US was down 18.1% from its record high on January 3 but recovered by 2.4% on Friday to avoid moving into a technical bear market. The NASDAQ composite has already dropped well into bear market territory with a year-to-date decline of 25.5%.

International bond markets are also going through a period of intense volatility. Despite the uncertainties related to economic growth, inflation across the globe is running at multi-year highs, which in turn is forcing major central banks to tighten monetary policy aggressively. Indeed, commonly-used bond benchmarks such as the Bloomberg Barclays Corporate Bond EUR Index registered a decline of 8.9% since January while the Markit iBoxx USD Liquid High Yield Capped Index has shed 6.7%.

Meanwhile, there were some sharp movements in currency markets too due to the monetary policy decisions being taken by major central banks. The euro vs USD exchange rate started the year at $1.13 and by the end of last week the dollar strengthened substantially to $1.035, marking the weakest point for the euro against the greenback since the start of 2017 when it had reached $1.0341.

The euro’s plight is mainly a function of US dollar strength as the Federal Reserve presses on with bigger interest-rate hikes than those being con­templated by the European Central Bank. In early May, the Fed raised its key interest rates for the second consecutive time (following the initial hike of 25 basis points in March) as the annual US inflation rate remained elevated at 8.3% in April. The Fed’s recent 50 basis point increase was the sharpest rise in 22 years. The Fed also decided to start its balance sheet reduction programme on June 1 by selling up to $47.5 billion worth of securities per month until August, rising to $95bn per month as from September.

Moreover, the US dollar is benefiting from its safe-haven appeal as risk aversion increases due to increased market turmoil and ongoing developments in Ukraine.

On the other hand, the outlook for the European economy is weakening. The International Monetary Fund recently slashed its 2022 growth forecast for the eurozone to 2.8% with potential further risks to the downside due to the severe impact of the war in Ukraine and the continuing standoff with Russia over the supply of natural gas. Moreover, earlier this week, the European Commission issued its revised economic forecasts for 2022 and lowered its economic growth forecast for the eurozone to 2.7% from the previous estimate of 4.0% as the war in Ukraine is severely curtailing the EU’s economic rebound from the COVID-19 pandemic. Meanwhile, the European Commission sharply increased its inflation forecast to 6.1% from the previous estimate of 3.5%. Inflation is expected to peak at 6.9% in the second quarter of 2022 and to decline thereafter until falling to 2.7% in 2023.

Europe’s weakening economic prospects is naturally impinging on the ECB’s monetary policy decisions. The ECB needs to balance the need for tighter policy to suppress the upsurge in inflation to record levels against the economic implications of such tighter monetary policy decisions. Although several ECB officials have clearly indicated that rates will rise above zero before the end of the year from the present level of -0.5%, there are continued doubts over further hikes beyond that level due to the uncertainty over the growth outlook due to the war in Ukraine.

Nonetheless, several investment banks are predicting that sometime during 2022, the euro will reach parity against the US dollar for the first time in two decades. This will likely make matters worse for the eurozone economy as a weaker euro would lead to higher imported inflation – a point that was also brought up this week by a member of the ECB Governing Council who warned that “a euro that is too weak would go against our price stability objective”.

A weaker euro would lead to higher imported inflation

The US dollar also exhibited strength towards virtually all other major currencies. The US dollar index, which measures the US dollar’s strength against a basket of other currencies, has surged to a near 19-year high. For example, against the Japanese yen, the US dollar has risen over 13% so far this year.

A stronger US dollar has various implications for the global economy. On one hand, it makes US exports more expensive, which may lead to a decline in revenue and profits for some large US exporters. Many US multinational companies generate sizeable profits from overseas so a stronger dollar is not a positive sign for US companies. For example, the largest US company by market value – Apple Inc – generates nearly two-thirds of its sales outside the US, so a stronger US dollar will impact the company’s profit margins. Similarly, Google’s parent company – Alphabet Inc – generates over half its sales from outside the US, so such companies will suffer from a strengthening US dollar.

In contrast, European companies with high exposure to North America may benefit from a weaker euro and a stronger US dollar. This may help some of the most renowned car companies such as Volkswagen, Mercedes Benz and BMW.

A rising US dollar tends to tighten financial conditions especially for emerging markets as they would face higher repayment burdens for US dollar-denominated debt. Moreover, a stronger US dollar results in higher commodity costs for non-US consumers which could in turn lead to subdued consumer demand.

One of the positive aspects of a stronger US dollar is that it causes a decline in US consumer inflation. As such, if the value of the US dollar continues to rise, the Fed may not need to tighten monetary policy as aggressively as anticipated, which would be welcome news for various asset classes.

Financial markets are essentially dealing with three major themes – persistently high levels of inflation, slower economic growth and tighter monetary policy. By raising interest rates sharply when the US dollar is already helping to pull down inflation, the Fed may be driving the economy into a recession, which is one of the key concerns affecting investor sentiment.

The ECB’s upcoming monetary policy meeting on June 9 is likely to be one of the main factors influencing the euro vs USD movements in the months ahead together with further economic data across the world, especially inflation data in the US.

 

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