The "darkest moment" for global risk assets may not yet come

Since the beginning of this year, global risk assets have experienced significant fluctuations. The setback in risk sentiment has led to a decline in US stocks and crypto assets; risk aversion has led to an 8.6% increase in the US dollar; the conflict between Russia and Ukraine and supply chain issues have caused commodities to rise by more than 40%; US inflation in May was 8.6%, a 40-year high, and expectations of interest rate hikes have led to an increase in US Treasury yields. Since the beginning of the year, US Treasury performance has been the worst in more than 40 years (see figure below).

Changes in major asset prices since 2022, data from investing.com

Future inflation and global central bank rate hikes will largely determine the trend of risk assets. As global inflation has risen beyond expectations (see figure below) , central banks in developed countries, led by the Federal Reserve, have aggressively raised interest rates, which has weighed on risk sentiment and risk asset valuations.

Most countries in the world face high inflation risks

Risk assets rose sharply this week, with the US S&P 500 up more than 6% and crypto assets such as Ethereum up more than 7%. However, the rebound in risk asset prices this week was a correction to the previous oversold situation for the following reasons:

First, the market's digestion and weakening of expectations for the Fed's future rate hikes. FedWatch data shows that traders' probability of a 75 basis point rate hike by the Fed in July has dropped from 89% to 83% (see the chart below);

Market expectations for a 75 basis point rate hike in July have weakened, data from CME FedWatch

Second, inflation expectations have fallen. For example, this week the University of Michigan's five-year inflation expectations fell from 3.3% to 3.1%, and the one-year inflation expectations fell from 5.4% to 5.3% (see the figure below).

The University of Michigan's inflation expectations fell this Friday, data from Bloomberg

In the future, risky assets will still face three major headwinds:

First, the Fed is more hawkish than expected. Although the market hopes that the interest rate will only be raised by 50 basis points in July, according to the latest article by Nick Timiraos, the Fed's "official mouthpiece" and Wall Street Journal reporter, the Fed is very likely to raise interest rates by 75 basis points in July (see figure below). Considering that the Fed has been behind the curve for a long time, that is, the current interest rate is still lower than the Fed's expected neutral interest rate of 2.5%, there is a risk that the future interest rate hike will be more hawkish than it is now, that is, after the 75 basis point rate hike in July, the interest rate will be raised by 50 basis points in September, and the interest rate will be raised by 25 basis points in the November and December meetings respectively.

Nick Timiraos latest news

Second, the US inflation has not yet reached a turning point, and there are still upward risks in the future. According to the inflation nowcasting released by the Cleveland Fed this week (see figure below), the US Headline CPI will rise to 8.7% year-on-year in June, up 1% month-on-month. Although there are differences in forecasts, judging from the service industry and rental inflation, US inflation may not have peaked yet.

Cleveland Fed's latest inflation forecast

Third, the United States is in stagflation, and U.S. stock revenue and earnings are lower than expected, which has suppressed stock prices. According to the first quarter financial reports of 2022, most companies mentioned the appreciation of the U.S. dollar, rising costs caused by inflation, and the impact of supply chain problems on their future revenue and profits. It is expected that these factors will continue to suppress U.S. stock prices and have a spillover effect on crypto assets. In addition, as of the end of the first quarter, U.S. resident deposits were already lower than pre-epidemic levels (see figure below). Although the decline in consumer spending will suppress demand and lower inflation, considering that U.S. inflation is constantly shifting towards stickiness, for example, the United States is likely to enter a longer period of stagflation in the future. These may be unfavorable factors for risky assets.

US residents' income has dropped sharply, which means that future consumption will be weaker

The sticky CPI calculated by the Atlanta Federal Reserve has risen to 5.2%

In summary, although risky assets have enjoyed a brief respite in the short term, the discussion about "inflation" is far from over. The risks of more persistent high inflation leading to Fed rate hikes and economic downturn still exist, and we still need to be vigilant against further pullbacks in risky assets in the future.