monthly outlook

November 2021Monthly Outlook

2Monthly Outlook November 2021

CIOs Letter

In Focus

Macro & Markets

Asset Allocation

Columns

Table of contents

Keep calm and carry on

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CIOs Letter

Co-CIO of Group Wealth Management and CIOUniCredit Bank AG (HypoVereinsbank) (Germany)

Philip Gisdakis

It was the concerns about slowing growth and rising inflation that hit equity markets hard after the summer break. Supply chain problems, soaring transport costs and energy prices, labour shortages and fears of a full-blown property crisis in China created plenty of nervousness across markets. In September, European indices fell by up to 4%, while their US counterparts fell even slightly more. At the same time, government bond yields rose noticeably. In October, equities indeed recovered and have made up their previous month's losses. But bond markets merely treaded water, and volatility remained high.

Behind this is the fact that the industrialised countries have probably left their growth peak of the post-pandemic recovery behind them. In Europe, the economy grew by a good 2% in the spring and summer compared with the previous quarter. Annualised, this is around 8.5%. According to consensus estimates, however, the pace of growth is likely to halve on average in the current quarter and the two following quarters, and then fall back to an annualised rate of just 2% in the second half of 2022. But even that is still more than pre-pandemic trend growth. In the US, the peak of the growth recovery is already somewhat further back. In spring 2021, the US economy grew at an annualised 6.7%. Momentum has slowed considerably this summer, but should remain above potential in the coming half-year (normalisation). For investors, the outlook is thus complex and ambivalent. On the one hand, the growth momentum should remain above pre-pandemic levels next year – at least according to consensus expectations – which actually supports equities, but on the other hand, the growth momentum is slowing noticeably and risks are increasing.

In such an environment, it is helpful to think in terms of scenarios. In our base scenario, which we believe has a higher probability of occurrence, we assume – as does the consensus – a gradual slowdown in growth, but still expect growth rates above the pre-pandemic trend. In such an environment, equities remain well supported and are also more interesting than bonds due to the expected rise in yields. This assessment therefore justifies an overweighting of equities over fixed income securities. However, as the outlook in a cooling economic environment is no longer as rosy as it was during the upswing of the recovery, we have reduced the overweight somewhat. To use an analogy from road traffic: if the traffic density increases, you slow down a bit and keep an eye out for dangerous situations. But you don't really have to put on the brakes.

Keep calm and carry on

Head of Group Investment Strategy and CIO Group Wealth Management

Manuela D’Onofrio


So, what is the risk scenario? The adverse factors are well known. The already established slowdown in growth after the peak of the post-pandemic recovery is being compounded by fears of even higher inflation rates, which in turn is putting the brakes on growth. In this context, inflation dynamics could be exacerbated by further increases in energy prices (for example, due to a particularly cold winter), persistent supply bottlenecks, transport costs that remain high, and new waves of infections in the autumn and winter. In addition, the global growth momentum could also cool more sharply than previously estimated as a result of an intensified real estate crisis in China. The scare word behind this is stagflation, i.e. stagnating economy accompanied by sharply rising inflation. Such an environment would not only be a major headache for central banks – they would have to tighten monetary policy due to inflation, which would slow down the weakening economy even more. Easing, on the other hand, would have no effect on the real economy, but at the same time would fuel inflation – but also for investors, as rising inflation would weigh on bond markets, while the sluggish economy would hit equities. Diversification across asset classes would then no longer work properly.

However, we believe that a truly stagflationary development is unlikely. It would therefore be a monetary policy mistake to tighten into a merely temporary inflationary spurt. However, the central banks' argument based on the temporary nature of inflationary forces ("transitory inflation") harbours a certain danger – for no one knows how long the phase will last. In addition to the inflationary push, which is likely only temporary, there is another reason for central banks to remain calm. The current high inflation rates are driven in part by base effects (last year inflation was low, and in some cases even negative), and in part by the supply shocks already described. Economists refer to the latter as "cost push" inflation. However, the central bank cannot solve supply problems with monetary tightening (OPEC, for example, would not increase output if the central banks in the industrial countries were to raise their interest rates). Accordingly, the motto is keep your nerve, even if inflation remains high for longer than expected. Incidentally, this does not mean that central banks should not gradually scale back pandemic-related measures such as bond buying programmes. However, "tapering", which is already priced in in the US, should not cause too many distortions if the central banks proceed gradually and cautiously. Therefore, additional monetary tightening does not seem appropriate for the foreseeable future.

CIOs Letter

... even if only after a certain period of time, since both the Fed and the ECB have now set themselves symmetrical inflation targetsand thus tolerate inflation overshooting 2% for a certain period of time.


In Focus

Central banks prepare for exit; Fed and BoE step up the pace

Global economy should continue to recover

The spread of the Delta variant weighed on the global economic recovery in the summer. However, falling numbers of new infections in many industrialised countries since September indicate that the negative effects of the pandemic are gradually fading. A still high level of demand on the consumer side, given the savings accumulated during the pandemic, and the need to replenish depleted inventories, suggest that growth in the industrialised nations will remain very solid next year. Against this backdrop, central banks are preparing to exit their pandemic-related measures (see chart 1), with the Fed and the Bank of England (BoE) in particular signalling an earlier than expected tightening of their expansionary monetary policies.

1. CENTRAL BANKS PREPARE FOR EXIT

Source: Refinitiv Datastream, UniCredit Wealth Management

Bank of EnglandECB

Federal Reserve

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Central banks balance sheet, in % of GDP

Collapse ofLehman Brothers

Beginning ofCovid pandemic


In Focus

Fed likely to start tapering securities purchases earlier

At its meeting in September, the Fed announced that it would begin to curb its bond-buying programme as early as November of this year and that it intends to end its net purchases entirely around mid-2022. As a reason for reducing bond purchases, the Fed points to the recovery of the US economy, reflected in substantial progress in inflation towards its 2% medium-term target, as well as continued improvement in the labour market. Specifically on inflation, the Fed has recently been guided by the strategy of average inflation targeting, in which it tolerates inflation overshooting its 2% target for a period of time. However, with current annual rates in the US consumer price index being very high at over 5%, and other US inflation measures also trending in this direction, this is likely to have contributed significantly to the exit from its expansionary monetary policy earlier than expected.

Consumer prices in particular have risen more strongly and more sustainably than the Fed had previously assumed (see chart 2). However, the year-on-year inflation rates shown in chart 2 are to a not inconsiderable extent, partly due to base effects resulting from the sharp declines in inflation during the peak of the pandemic a year ago. In addition to these base effects, supply-side constraints on materials and inputs and the recent energy price shock are also driving inflation higher (see our Macro & Markets section). Despite this unexpected development, the Fed continues to believe that the current very high inflation rates are only temporary – and rightly so, in our view.

2. INFLATION RATES ARE WELL ABOVE THE TARGET OF 2%

The current monthly pace of purchases of US government bonds and mortgage bonds totaling USD120 billion is to be reduced gradually.

Under the average inflation targeting approach, the Fed aims to achieve an average inflation rate of 2% over a given period. In this context, a (moderate) overshooting of the inflation rate above the 2% target is tolerated for a certain period of time if inflation has previously been below that target. However, neither the exact duration nor the exact level of future deviations is clearly defined.


The PCE index measures price increases in private consumption expenditure in the US (Personal Consumption Expenditures) and is regarded as the Fed’s most important price indicator. Similar to the consumer price index (CPI), the PCE index is based on a defined basket of goods and services, which differs from that of the CPI. In addition, the CPI survey is based on household purchases, while the PCE index survey is based on business sales. In both cases, the core rate refers to the respective index excluding food and energy items.

PCE index (headline rate)Consumer price index (headline rate)

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US inflation measures (in % yoy)

Average inflation target of the Fed


In Focus

As a result of the improved macroeconomic environment, the Fed is now also assuming an earlier date for a first interest rate hike in its interest rate projections. While at its June meeting the majority of the Fed still did not expect a rate hike before the end of next year, the members of the Federal Open Market Committee (FOMC) now assume that there could already be a rate hike next year. The so-called “dot plot” recently showed an even distribution of votes for and against a rate hike next year (see chart 3). The earlier timing of a first hike follows the Fed’s principle of sequencing the rate-hike cycle as soon as possible after the end of net purchases. The Fed’s own interest rate projections also signal three further rate hikes of 25 basis points (bps) each in 2023 (compared with two in June), followed by three more hikes in 2024. In our view, the first rate hike of 25 bps will take place in early 2023, followed by a second step of the same size in the second half of the year.

3. FED DOT PLOT SIGNALS FIRST RATE HIKE IN 2022


The BoE is also stepping up the pace. Although it announced at its last meeting in September that it was sticking to its expansionary monetary policy, two members of the Monetary Policy Committee (MPC) have already called for an early end to the purchase programme (compared with only one member in August). Moreover, the MPC sees the conditions for economic recovery as largely met, so that a moderate tightening of monetary policy within its forecast horizon until 2023 is likely to be appropriate. This was also supported by recent comments from BoE Governor Andrew Bailey, who stressed that the central bank must act to counter medium-term inflationary pressures, even though he regards the current high inflation rates as temporary. We believe that the MPC’s outlook lays the foundation for a possible 15 bps rate hike as early as February next year.

The dot plot depicts the expectations of the voting members of the FOMC regarding the Fed’s future interest rate policy. Each dot in chart 3 represents a member of the FOMC. For each year, the median is then calculated across the individual dots, which then represents the expected target rate of the Fed and thus the associated number of expected interest rate hikes.

At its September meeting, the British central bank left its key interest rate unchanged at 0.10% and also confirmed its programme of purchasing government and corporate bonds totaling GBP895 billion.

Median calculated across dotsVoting member of the FOMC

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FOMC participants' assessments of appropriate monetary policy: Median reflects midpoint of target range for the Fed’s target rate (in %)

1.75

1.00

0.250.13


In Focus

ECB plans end of pandemic emergency programme in early 2022

In the euro area, the ECB seems intent on phasing out its Pandemic Emergency Purchase Programme (PEPP) only in March 2022. In order to prevent a so-called “cliff”, i.e. an abrupt drop in bond purchases, and to ensure a smooth exit from the PEPP that keeps financing conditions in the euro area stable, the ECB is already considering a further purchase programme. This could then come into force in addition to the APP purchase programme, which is running in parallel. Instead, however, a higher pace of APP bond purchases as well as an increase in APP flexibility would also be conceivable, e.g. with regard to asset classes and countries. The ECB is also likely to start raising interest rates only after it has ended its net purchases under its asset purchase programmes. This suggests that interest rates will remain at their current level for some more time to come. Accordingly, financial markets currently assume – as measured by the OIS yield curve (overnight index swap) – that the first increase in the ECB deposit rate of 10 bps is not to be expected before the end of 2022 (which is too early in our eyes), and that it will not reach zero again until mid-2025 (see chart 4).

4. FINANCIAL MARKETS PRICE IN FAIRLY EARLY INTEREST RATE HIKE

Source: Refinitiv Datastream, UniCredit Wealth ManagementPlease note: Past performance and forecasts are not reliable indicators of future performance. Indices may not be purchased and therefore do not include costs. When investing in securities, costs are incurred which reduce the performance. As at: 28.10.2021.

The APP (Asset Purchase Programme) comprises purchases of various groups of securities in the euro area. Under this programme, the ECB currently purchases government bonds and corporate bonds with a high credit rating (investment grade), as well as asset-backed securities and covered bonds totaling EUR20 billion per month.

The overnight index swap is an interest rate swap transaction in which a fixed interest rate is exchanged for an EONIA. The EONIA is the interest rate at which unsecured overnight deposits are exchanged on the interbank market in the euro area.

ECB deposit rate

-0.4%

0.6%

0.4%

-0.6%

0.2%

-0.2%

0.8%

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1.0%

2010 20222016 20282012 20242018 20302014 20262020 2032

1M EUR OIS forward curve,adjusted for 1M OIS-deposit rate spread


Macro & Markets

Stagflation? No, however...

Will the summer slump be followed by a cloudy autumn – and even a cold winter? In any case, the wrinkles of concern among analysts and investors have deepened. The phantom of stagflation is haunting. The series of supply shocks – from supply chain problems, to rising transport costs, to soaring gas and energy prices, to labour shortages – is likely not only to fuel inflation, but also to slow down the global economic momentum further. Week after week, inflation expectations are revised upwards and growth forecasts are down. We, too, have to make adjustments.

However, what may feel like stagflation at first glance is not, and neither do we believe that it will become this. Despite the accentuated slowdown, the global economy should continue to grow above potential over the coming months (supported by catch-up effects and economic policy stimuli), while inflation is likely to fall again in the medium term, simply because of base effects and declining pent-up demand. At the same time, long-term inflation expectations are well-anchored thanks to the credibility of central banks. However, inflation is likely to increase further in the short term and thus prove more stubborn and protracted than previously estimated. Moreover, global growth continues to fall short of initial expectations in the autumn and winter quarters as well. This time, Europe could be hit harder than the rest of the world. In the summer, the focus was still on China and the US.

Supply chain problems likely to be more protracted than expected

Up to now, it was mainly the Covid-induced disruption of (global) supply chains that caused problems for goods producers – combined with the hope that tensions would soon be eased. Empirical studies and an initial silver lining in such important indicators as delivery times and inventories fuelled this expectation – all the more so when Covid began to lose its grip, at least in the developed economies, thanks to the progress made in vaccinations.

However, hopes of a relatively rapid improvement seem to have been dashed, as the situation has worsened recently. According to the Ifo business survey, 77% of German manufacturers are now complaining about bottlenecks and problems in the supply of primary products and raw materials – a new record high. In August,

Stagflation describes a situation of economic stagnation coupled with rising inflation. Stagflationary phases are usually triggered by supply shocks. The most prominent example of stagflation is the 1970s, which was triggered by rapidly rising oil prices (oil price crises).

For the details of this, see our comments in the September Monthly Outlook, p. 12.

Most recently, sports goods manufacturers joined the fray, now that Vietnam has dropped out of the global supply chain altogether due to Covid.


Manufacturing Production (EMU, index)

Retail sales (EMU, index)

Auto Production (EMU, index)

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the figure was just under 70%. In the particularly hard-hit automotive sector (due to a lack of semiconductors), short-time work and plant closures (Opel/Stellantis) even occurred again – instruments that are fatally reminiscent of the early days of the pandemic. Worse still, supply problems have now reached retail trade. Three out of four retailers report supply shortages and warn of bottlenecks during the Christmas season, with the consequence that they too are now setting their sights on price increases.

In other EMU countries, which are also strongly integrated into the global economy, the picture is unlikely to be much different from Germany. The gap between (car) production on the one hand and (realised) demand on the other has widened further in the euro area as a whole (see chart 5).

5. EMU: HUMMING DEMAND, FLAGGING PRODUCTION

Macro & Markets

For details see (here) (The world’s top central bankers see supply chain problems prolonging inflation. - The New York Times.)


Against this background, it is difficult to continue to bet on a rapid improvement. This is, in the meantime, not only our view, but also that of the central banks. In fact, European Central Bank (ECB) chief Christine Lagarde recently said at the Central Bank Forum that the supply chain problems are "a threat to growth". It is unclear how long these bottlenecks will last. US Federal Reserve (Fed) chief Jerome Powell was even more specific, stating that the supply chain problems will likely drag into next year, keeping inflation at a higher level for longer than expected.

And as if the supply chain problems were not enough of a burden, there are also shortages of transport capacity, energy and labour. Here, too, swelling demand meets limited supply – which was noticeably reduced during the pandemic – and a lack of spare capacity or empty stockpiles. This increases the pressure on inflation and production equally.

In the bicycle retail sector, even 100% of respondents reported delivery problems (link)

https://www.ifo.de/en/node/65598

https://www.nytimes.com/2021/09/29/business/central-bankers-supply-chains-inflation.html


Macro & Markets

Rapidly rising transport and energy prices

It is not only for the pre-products themselves that the companies have to dig deeper into their pockets, but increased transport costs are also causing them more and more trouble. Container freight in particular has become extremely expensive. Since the beginning of the pandemic, the price indices have risen by a factor of between seven and eight, depending on how they are calculated (see chart 6).

6. TWO INDICES, ONE MESSAGE: SOARING TRANSPORT COSTS

On selected routes, the increase in transport costs is even more striking. This applies not least to the route from China to the US West Coast (factor 13). In some cases, container ships even have to return empty.

Due to the Brexit, around 20,000 foreign drivers have left the UK (reservations against migrants, visa requirements). In addition, the working conditions are said to be poor. And in times of Covid, many truck drivers would have given up their jobs.


But this is not the end of the suffering story for importers. For example, container ships are currently two to three times longer than usual off or in the port of Los Angeles until the cargo can be unloaded – and this is certainly not an isolated case. The goods then have to be distributed further by truck. The acute driver shortage and its consequences for the supply of the economy in Great Britain went viral – although the issue there is still being potentiated by Brexit. However, other (developed) economies also face the basic problem of scarce transport capacities.

This applies all the more to the energy price shock, which only recently came to the attention of investors. The worries were triggered by the explosion of natural gas prices, especially in Europe, as well as in Asia. Within 12 weeks they have tripled, and since the beginning of the pandemic they have even increased 12 fold (see chart 7).

Container freight rate (Freightos Index)Baltic exchange dry index (right scale)

Jan 16 Jan 19Jan 17 Jan 20Jan 18 Jan 21

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Covid pandemic


Europe is at the lower end of the range because of a fairly high fixed tax component; this dampens transmission. The US, on the other hand, tends to be at the upper end.

7. SURGE IN NATURAL GAS PRICES ALSO HAS AN IMPACT ON OIL PRICES

Macro & Markets


The reason is a well-known one: a noticeable increase in demand in the run-up to the heating season in the northern hemisphere meets a far below-average stockpiling coupled with insufficient supply. For example, the Netherlands recently announced the end of natural gas production in Groningen (environmental concerns), in Norway maintenance work noticeably slowed down production, and in the Gulf of Mexico, the hurricane season created headwinds. Russia, however, plays a special role in the supply of natural gas to Western Europe. There are accusations that Vladimir Putin is keeping supplies tight in order to "force" the opening of the Nord Stream 2 pipeline. It is possible, however, that Russia has production problems of its own or is now giving priority to meeting the swelling demand for liquefied gas from Asia – at a higher price. After all, the world's largest natural gas importer, China, is in the midst of an energy crisis.

As dramatic as the gas price increase may seem, in macroeconomic terms it would hardly have a lasting braking effect on inflation and the economy, because it is comparatively insignificant. Nevertheless, this is no reason to sit back, as the gas price is now having an impact on oil prices (substitution, see chart 7). After the dip this summer below USD70 per barrel, oil prices have now reached the USD85 mark – a level that was only targeted at the peak of the heating season at the turn of the year. Crude oil, however, is clearly the more important economic factor. A rule of thumb says that a price increase of USD10, if sustained, will raise consumer prices by 0.3-0.5 percentage points. In arithmetical terms, there would be an inflationary impulse of about 0.75 of a point in the current quarter. While this is a veritable additional burden, it is by no means a dimension that should fuel inflation angst. Only if the oil price quickly reaches the USD100 mark and stays above it will inflation threaten to get out of hand.

But we do not want to go that far. On the one hand, we are already seeing the first signs of easing. Natural gas prices have recently fallen by roughly 10% and the oil price has stabilised. The scope for upward movement seems to have been largely exhausted because the energy shortage is now widely priced in. On the other hand, the macroeconomic demand overhang will melt away as growth slows down further and normalises. At the same time, the pressure on the producing countries to ramp up production is growing, in order not to endanger the world economy. In addition, European governments want to either limit the

Oil price Brent (USD/barrel, right scale)Natural gas price (Europe EEX, EUR/MWh)

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Stringent decarbonisation requirements, water shortages and high gas prices have already led to widespread power cuts and plant shutdowns in China this summer. The start of the heating season (central supply, priority for households over industry) has exacerbated the problem. In other parts of Asia, stocks of natural gas and crude oil are also below average. Bottlenecks already occurred there last winter.

Moreover, with the higher prices, marginal suppliers (fracking, oil shale) can produce more profitably again and will return to the market.


Macro & Markets

rise in energy prices (at the consumer level) or at least compensate for it (energy cheques). Overall, we really do not expect a long-lasting surge in inflation, and certainly not like in the 1970s.

Increasing labour shortage puts pressure on wages

That leaves one last new shortage, that of labour. Just like the problems discussed so far, this supply shock occurs unusually early in the cycle. It primarily affects the Anglo-Saxons.

This may come as a surprise at a first glance, since the US unemployment rate, at 4.8%, is still above its pre-pandemic level of 3.5%. Moreover, the closely followed US labour market reports were quite disappointing over the past two months.

However, this is primarily due to a lack of labour supply. It cannot keep up with the rising demand. US labour force participation has even declined. This may be partly Covid-related, and partly due to government support, which has now ended. At the same time, the ratio of job openings to new hires rose to a new record high. This also applies to the number of (voluntary) dismissals (see chart 8). Companies are finding it difficult to fill vacancies and employees are more willing to change jobs for better conditions. It is no wonder that the tight labour market is putting increasing pressure on wage costs. US hourly wages, for example, recently increased significantly to 4.5% compared to the previous year. It will become critical when a wage-price spiral occurs. However, that is not yet the case (forecast risk).

8. TIGHTNESS IN THE US LABOUR MARKET


The labour market is also tightening in continental Europe. At 7.5%, the EMU-wide unemployment rate has (almost) returned to its pre-Covid level. Nevertheless, there are no signs of wage growth picking up. Currently, unlike in the US, the rate in collectively agreed wages is still historically very low fluctuating around 1.5% (see chart 9). This is due to the different labour market systems. Anglo-

Instead of the expected 575,000 in September and 625,000 in August, only 194,000 and 235,000 new jobs were actually created, respectively.

In the UK, the labour market is similarly tight, thereby accentuated by the Brexit fallout.

Quits (in thousand, right scale)Ratio of job opening to hire

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Macro & Markets

Saxon markets are considered very flexible ("hire & fire"), and wages react faster to a changing economic environment. European companies, on the other hand, use instruments such as short-time working allowances to keep their employees in companies even in times of crisis, but then save on search and recruitment costs. The wage-setting process (collective bargaining) also smoothes wage developments over the long term. We therefore do not expect overly strong increases in the coming quarters.

9. EURO AREA: NO SIGN OF WAGE COST PRESSURES


Inflation: More pronounced and persistent, but still temporary. Inflation expectations remain well anchored

Against the backdrop of the unexpected and early clustering of supply shocks, we too cannot avoid pulling the path of our inflation forecasts upwards and backwards (see chart 10).

The latest wage settlements for Germany imply an increase of 2%-2.50% (year-on-year in each case) over the next 24 months. The landmark IG Metall wage agreement is not due until the end of next year.

Negotiated pay (% yoy)

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Macro & Markets

10. INFLATION: HIGHER AND MORE PERSISTENT, BUT TEMPORARY


Contrary to our expectations, consumer prices are likely to continue to rise over the coming months and may touch or even exceed the 4% mark (EMU) or 6% mark (US) temporarily. Inflation will probably peak at the turn of the year. It will then take one or two quarters longer for inflation to find its way towards the targets of the ECB and the Fed. What has not changed, however, is our conviction that the rise in inflation will remain temporary. Why?

1. The bulk of the current rise is due to base effects. That means even the most recent rise in energy prices will likely not show up in the year-over year statistics after 12 months.

2. Once the pent-up consumption has been worked off, the current excess demand will melt away. Moreover, supply shortages beyond the short term should gradually diminish.

3. We do not expect any second-round effects (wage-price spiral), especially not in the euro area.

4. Medium-term inflation expectations are well anchored on both sides of the Atlantic despite recent increases (see chart 11), thanks to central banks.

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Central banks’ mid-term inflation target Forecasts

US headline inflation (% yoy) Prior US forecasts EMU headline inflation (% yoy)Prior EMU forecasts

Currently, consumer price inflation stands at 3.4% in the euro area and 5.4% in the US.

The risks for the US are higher, but also remain manageable.

Quartely figures


Macro & Markets

11. INFLATION EXPECTATIONS WELL-ANCHORED

Source: Refinitiv Datastream, UniCredit Wealth Management. Please note: Past performance and forecasts are not reliable indicators of future performance. Indices may not be purchased and therefore do not include costs. When investing in securities, costs are incurred which reduce the performance. As at: 28.10.2021.

Growth momentum continues to weaken in the current quarter

While we had the demand pull (pent-up consumption/dis-savings) in the wake of the economic opening on our agenda, we underestimated the flexibility of the supply side. Consequently, supply shocks not only continue to push prices up, but also continue to slow the recovery in winter.

On the one hand, a lack of raw materials and intermediate goods directly depresses the production of goods. On the other hand, the parts of rising costs that cannot be passed on reduce companies' productivity. The strongest economic dampening effect, however, results from the sharp rise in inflation, which considerably reduces the real purchasing power of consumers.

Since our expectations of an annualised double-digit GDP increase in the euro area for the summer are already unrealisable, this applies all the more to the current quarter. The retail sector already seems to be losing momentum, production has recently declined again, business sentiment continues to deteriorate, and new orders have already been much higher. For the last three months of the year, we therefore expect real GDP in the euro area to increase only by an annualised 3.5% (or just under 1% quarter-on-quarter; previously: 5.5% and 1.25%, respectively).

This is a marked slowdown after two strong quarterly increases, but still well above potential – and of course far from being a stagnation. Support comes from the consumption backlog, which has not yet been cleared, and the surplus of savings, respectively, as well as the rising output of the service sector as the pandemic subsides. Added to this are the ongoing fiscal (EU recovery funds) and monetary stimuli – even if the central banks are preparing to exit their highly accommodative policy (see our In Focus section). Moreover, despite the recent setbacks, sentiment indicators are clearly in expansionary territory. And because the pre-pandemic GDP level has still not been reached, growth across the EMU

EMUUS

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Implicit inflation expectations (in 5Y for 5Y, %, derived from inflation swaps)

For some marginal producers, this could also mean the end of the business.

EMU-wide real GDP is unlikely to have grown by much more than a still-strong 7%-8% annualised in Q3 2021 (or 1.75%-2% quarter-on-quarter; Q2 2021: +9.2%). The figures will be published at the end of October.

Currently, the Composite Purchasing Managers' Index for the euro area stands at 54.3 points, still well above the critical threshold of 50 that separates economic expansion from contraction.


Macro & Markets

is likely to remain above potential going forward – and may even be somewhat stronger again in the next two quarters as supply shocks lose their impact. After that, overall economic growth will likely gradually weaken to trend anyway (see chart 12).

12. GROWTH SLOWDOWN, NO STAGNATION


In the US, however, post-Covid normalisation is already underway, after the pre-pandemic level was already reached last spring. GDP growth should have already weakened noticeably this summer (+2% annualised, Q2: +6.7). As in the euro area, it is quite possible that US growth will be somewhat higher again in the coming quarters, but then finally weakens to potential (1,75%-2%).

Let us add a word on China. In the past quarter, the economy was indeed only treading water. We had expected this against the background of excessive economic policy tightening and the emerging energy and real estate crisis – combined with the hope that the usual economic policy countermeasures would quickly bring the economy back to its potential course. However, this hope has recently been dashed. Not only is Beijing allowing large real estate developers to go bankrupt and rigorously implementing its decarbonisation goals (in other words, power cuts at (state) enterprises), the government now also seems to be placing a stronger focus on qualitative growth. However, if the extent of the countercyclical measures falls short of our expectations, the same applies to economic growth. It is quite possible that, at around 5%, China will not reach its previous potential in the future. But this is not stagnation either.

Overall, economic stagnation, as suggested by the phantom of stagflation, is unlikely in the foreseeable future – not only in the EMU, but also in the US, China and the global economy. This is all the more true at a time when fiscal policy is launching investment programmes worth billions of euros and USD to combat the climate crisis and modernise national economies. Even Germany, a long-time procrastinator, now seems to be giving up its reluctance, as suggested by the current coalition talks (see the section "Answers from Germany").

US GDP figures for the third quarter will be published on October 28.

According to official figures, the Chinese economy grew by 4.9% year-on-year in the summer quarter, but only 0.8% in the more important quarter-on quarter comparison. On the basis of alternative seasonal adjustment methods, however, globally acting investment houses arrive at negative growth of up to 3% annualised, quarter-over-quarter.

H2 21H1 21

H1 22H2 22

1

2

3

8

7

0

6

4

9

5

10

World EMUUS China

Real GDP (% yoy, annualised)

Growth potential


Asset Allocation

Stagflation fears will not derail our constructive view on risk assets

In recent weeks, equity and bond markets have been characterised by fears of stagflationary dynamics – i.e. a reduction in global growth associated with high unemployment (economic stagnation) and more persistent inflation, with the latter linked to reopenings, supply restrictions and energy price increases.

A scenario characterised by low growth and higher inflation makes it very problematic to defend portfolio returns: equities are in fact penalised by the negative revision of earnings per share, especially when valuations are expensive, while bonds are negatively affected by the rise in interest rates, a process that central banks are forced to carry out in order to cool inflationary dynamics, as occurred in the 1970s and in the first part of the 1980s. In other words, there is a positive correlation between the prices of equities and those of bonds that undermines traditional balanced portfolios. The only assets that can protect the portfolio in a full stagflation scenario are inflation-linked bonds, gold and, in nominal terms, cash.

1DM = Developed Markets (Australia, Japan, Hong Kong, New Zealand, Singapore)

NEUTRAL POSITIVE

INVESTMENT VIEW

ASSET INVESTMENT UNIVERSE NEGATIVE

MAIN ASSET CLASSESIN DETAIL

EQUITIES

BONDS

COMMODITIES

MAINASSET CLASSES

Global EquitiesGlobal BondsMoney MarketsAlternativesUSEuropePacific (DM1)Emerging MarketsEMU Governments BondsNon-EMU Government BondsEUR IG Corporate Bonds

Emerging Market BondsOilGold

HY Corporate Bonds


Asset Allocation

Source: Board of Governors of the Federal Reserve System (US), UniCredit Wealth Management

How should we target our portfolio asset allocation?

Rising inflation and the expectation of higher government bond yields support our structural underweight on global bonds. Bond portfolio returns, net of fees, will be limited to inflation hedging, with real yields at zero or negative levels. This suggests reducing the weight of bonds, reducing the duration risk, focusing on corporate bonds and, selectively, Emerging Market bonds. It also suggests strategically increasing the weight on equities and taking advantage of any corrections.

In the detail of our regional equity allocation, we stick to our top overweight Europe, which we expect to be well-supported by higher vaccination rates and improving earnings growth. European equity markets benefit from a high weighting of cyclical and value sectors. In addition, in the Green Economy, thanks in part to the Next Generation programme, Europe is gaining global leadership positions. We are also overweight Emerging Market equities, although in the short-term they may be penalised by the China slowdown. We remain neutral on the US, where growth prospects are supported by Biden's very expansive fiscal policy, but the valuation is less attractive relative to non-US areas. We remain market weight Japan, supported by the global recovery and the high weighting of value/cyclical sectors.

Stagflation is also feared by economists, in fact, when inflation is caused by an upward spiral of wage claims, coupled with a supply shock – as occurred in the 1970s. Its cooling process by monetary authorities becomes more difficult and painful, because rising interest rates compress demand and growth in the economy for a prolonged period of time.

Although in the short term they will continue to affect the markets, fears of stagflation are to be considered excessive because global growth is expected to remain solid and above potential – and is likely to be the case in 2022 as well as in 2023. (See the Macro&Markets section above)

In the US, the level of Fed funds remains far below what would be required by the trend of GDP and inflation, as suggested by the Taylor Rule (the rule for the determination of short-term rates created by economist John B. Taylor). And above all, the new cycle of rate increases, expected starting from the first half of 2023, would end at a much lower level than those of past years.

13. FEDERAL FUNDS EFFECTIVE RATE

Federal funds effective rate (in %, shaded bars mark US recessions)

1960 1970 1980 1990 2000 2010 2020

10.0

12.5

7.5

17.5

15.0

20.0

0.0

2.5

5.0


In terms of sector allocation, we expect the rotation into value sectors to continue with energy and banks the most likely beneficiaries. We believe the latter are clearly supported of the steepening of the yield curve. Attractive dividend yields, which in Europe are well above government and corporate bond yields, may benefit from the current environment of lower growth and higher inflation.

14. US 2-10-YEAR TREASURIES YIELD SPREAD (IN BASIS POINTS)


Also, as shown in the graph below, the Global Earnings Revision Ratio is falling, but is remaining above average.

15. GLOBAL EARNINGS REVISION RATIO FELL FROM 1.21 TO 1.10 BUT REMAINS ABOVE AVERAGE

Asset Allocation

2016 2017 2018 2019 2020 2021

80

60

40

20

0

-20

160

100

120

140

Source: BofA Global Quantitative Strategy, MSCI, IBES, UniCredit Wealth Management

And the first evidence of the 3Q-21 results from US companies are encouraging. One week after the start of the US earning season, revenue growth estimates for the quarter remained unchanged at +14.1%, while earnings growth estimates increased from 29.4% to 32%. The improvement is mainly attributable to the financial sector.

1-month earnings revision ratio3-month earnings revision ratio

0.8

0.6

0.0

0.4

1.2

0.2

1.6

# St

ocks

Upg

rade

d / #

Sto

cks D

owng

rade

d

1.4

1.0

88 0094 06 1591 03 1297 09 1889 0195 07 1692 04 1398 10 19 2190 0296 08 1793 05 1499 11 20 22

Average earnings revision ratio


In Europe, early evidence on the quarterly reporting season shows that 58% of reporting companies beat EPS expectations, with a "net beat" of 37% aligned with 2Q-21 results. Expectations are that, as the numbers are released, this percentage may decrease, but it is still a good result given the operational challenges companies are facing (primarily over increased raw material costs and logistics issues).

We will come back to this topic in the next Monthly Outlook.

In terms of the risks scenario, we see the main sources of concern related to a permanent overshooting of inflation, leading the main central banks to become more restrictive than consensus and a more pronounced China slowdown, due to the property sector crisis and higher energy prices, which are affecting global growth.

UniCredit GWM Asset Allocation stances

Overweight Global equities The combination of massive fiscal and monetary action and the global recovery supports equities, despite uncertainty due to the pandemic. Overweight European equitiesMonetary and fiscal policies are highly expansive. Higher weighting of value and cyclical sectors versus the US equity market and attractive dividend yields, which are well above government and corporate bond yields. Neutral US equities Higher growth due to Biden’s very expansionary fiscal policy, but a less attractive valuation versus non-US areas. Overweight Emerging Market equities Attractive valuations and improving vaccination rate, but in the short-term, China’s slowdown is a source of concern. Countries and sectors selectivity among EMs is strongly recommended.

Neutral Pacific equities Japanese equities are supported by the global recovery and the high weighting of value/cyclical sectors, which we prefer to play in Europe.

Underweight Global bondsVulnerable to increasing inflation and the expectation of rising government bond yields.

Overweight Euro investment grade corporate bonds Still supported by the ECB’s purchases, but their tighter spread buffer makes them more vulnerable to rising interest rates. We prefer financial subordinated debt, given the increased capital buffer of European banks and shorter duration.Underweight high yield corporate bondsAttractive carry play, but, among the risk assets, we currently prefer equities as the lack of market liquidity remains an issue for high yield bonds.

Asset Allocation


Underweight EMU government bonds We underweight core Euro governments bonds, given their high benchmark duration. We prefer peripheral government bonds, such as Italian and Spanish govies, supported by the ECB and the Recovery Fund. Preferring a short duration and selectively increasing the positioning on inflation-linked bonds may prove helpful to deal with the base-scenario of a temporary increase of inflation.

Neutral non-EMU government bonds Despite still accommodative monetary policies, we expect US Treasury yields to increase by year-end.

Overweight Emerging Market bondsThe search for yield supports our positive stance, but we are more defensive and selective given the expectations of rising US Treasury yields.

Neutral Money MarketsTo be used mostly as liquidity parking and hedging for uncertainty.

Neutral AlternativesThey offer portfolios de-correlation opportunities.

Commodities

Positive GoldThe price of gold is sustained by central banks’ accommodative monetary policies and its hedging role during periods of uncertainty.

CurrenciesThe divergence between the monetary policies of the Fed and the ECB support the USD.

Asset Allocation


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Local CIOs in dialogue with the clients

Our experts:Answers from Italy

Should we fear central banks’ tapering?

Let’s start by defining “tapering” as the gradual reduction of liquidity injections, determined by bond purchases, by the central bank in the financial system. This typically happens in a period of expansionary monetary policy, when the central bank signals it wants to take a less dovish stance that could end, eventually, in neutral monetary policy initially – before becoming restrictive policy (this happens when the central bank drains liquidity from the system or hikes reference short-term interest rates).

So, “tapering” per se is still a supportive monetary policy tool, although it does signal that monetary conditions could be less supportive in the future. Anyway, and much more importantly, to better understand the potential negative impact of tapering are the timing, size and starting conditions.

When it comes to timing, it is a shared opinion that in the US, tapering is likely to start in the next month. Many economists believe that the Fed should have started to taper months ago, when it clearly emerged that the global economic recovery was gaining traction. Recently, the Fed President gave clear guidance that labor market conditions should improve before starting the process. On the other side of the ocean, the ECB President affirmed that the Pandemic Emergency Purchase Programme (PEPP) will last at least until March 2022, and even most hawkish ECB members have always supported the necessity, in case of a scale down, to act very gradually. So, the impression is that central bankers have preferred to wait some more months than to risk hampering the recovery in a complex economic environment.

CIOCordusio Sim (Italy)

Alessandro Caviglia


When it comes to the size, the Fed is currently injecting about USD120 billion per month, and the ECB EUR80 billion per month. A probable size of reduction for both is around 15 billion per month, in their respective currencies. So from the starting month, we will still have around six to eight months of a net positive increase. We should also remember that for ECB, the PEPP is an additional support programme, on top of the Asset Purchasing Programme (APP) launched in 2015 and reactivated in 2020, which is currently operating under the radar with EUR20 billion purchases per month. Once the net positive contribution will be zero, central banks will start reinvesting bonds maturing to maintain asset stability. This will be the neutrality phase that could last an additional six to eight months. The ECB has already stated that assets reinvestment will last at least until March 2023.

Last, but not least, we must consider current monetary conditions. From a historical point of view, the Fed and ECB currently have their highest level of assets on their balance sheet as a percentage of GDP: 40% the first, 60% the second (the Bank of Japan and Swiss National are at 120% and 140%, respectively). And central banks in the western world have been, since the pandemic broke out in 2020, the main buyers in government bond secondary markets. Their role in the economy and financial markets has never been so relevant, and current monetary conditions are, by several indicators, the most favourable in decades signaling therefore abundant liquidity. Just to mention some, current real yields on 10-year US Treasuries TIPS (Treasury Inflation Linked Notes) are at -1% and the same tenor inflation linked German Bunds real yields are even lower at -2%, record lows. Negative real yields are powerful stimuli for fixed investments and prospective growth.

In conclusion, yes, tapering is about to start, but gradually in terms of timing and size – and against an extra loose monetary policy environment. Economies and financial markets will be able to absorb it, and maintain potential growth and a positive outlook.

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Answers from Austria

What happens if Congress cannot agree to raise the US debt ceiling?

In recent weeks, investors' worry lines have increased with regard to developments across the financial markets. In addition to rising commodity prices and higher-than-expected inflation, the necessary raising of the debt ceiling in the US and the threatened closure of US federal authorities (the "government shutdown") have been much discussed topics. Since the debt ceiling and the closure of US authorities are not familiar topics to many readers in Europe, we look at the implications and challenges of both these events. In the free encyclopedia "Wikipedia", you can read the following explanation:

A government shutdown in the United States describes the situation in which agencies of the federal government cease much of their activity and perform only those operations that are considered essential. The state and administrative apparatus shuts down in such a shutdown when the previous legal basis for the approval of budget funds expires and the Senate, House of Representatives and President do not agree on further budget funds in time by passing a corresponding law.

This autumn, however, a government shutdown loomed once again. Congress did pass a spending authorisation at the last moment that ensures funding for federal agencies until 3 December, but the debt ceiling problem has not been solved.

In the background of this tricky situation, a battle is raging between the Democratic and Republican parties over two massive investment packages for infrastructure projects and social programmes that President Joe Biden wants to get through Congress. However, the Democrats' narrow majority in Congress limits Biden's maneuverability. Even within the Democratic Party, there is disagreement over the size and details of the two packages, and Republicans are refusing to approve them because they think the trillion-dollar packages are too expensive. In addition, there is pressure on Biden as his poll numbers have been falling since the withdrawal of the US military from Afghanistan.

What happens if Congress cannot agree to raise the debt ceiling? If the ceiling is not raised, the government cannot borrow more money, cannot meet its obligations and cannot pay its maturing old debts. The US has often been in this precarious situation in the past, where government shutdown becomes a reality. However, the acting parties have always been able to come to an agreement at the last minute. The financial markets

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Co-CIO Bank Austria and Schoellerbank (Austria)

Oliver Prinz


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do not appreciate this uncertainty, despite the high probability of an agreement. The closer the time comes to the possible default, the more volatile the markets become.

In conclusion, despite the storm clouds in the financial markets and the prospect of higher volatility in the equity markets, the glass is at least half full. Investors should continue to use the equity markets to build capital and remain invested. Those who wait too long for a correction could miss the boat.

Answers from Germany

What is the situation regarding the formation of a government in Germany?

The signs clearly point to the formation of a traffic light coalition under Chancellor Olaf Scholz. The exploratory talks have been concluded and the three parties – SPD, Greens and FDP – have agreed on the principles. The exploratory paper has now been rubber-stamped by the respective party committees, and coalition talks have begun.

The focus of the government's future work will be on investments in digital infrastructure. To this end, planning and approval processes are to be accelerated, the gigabit expansion is to be driven forward, the administration is to become more flexible and a comprehensive digital policy strategy is to be developed.

On the other hand, technological innovations and new business models are to be used to counter the climate crisis and ensure climate-neutral prosperity. To this end, the expansion of renewable energies such as photovoltaics and wind power is to be driven forward, and the phase-out of coal brought forward to 2030. Electricity costs are to be reduced by abolishing the levy for the expansion of renewable energies. In addition, only CO2-neutral vehicles are to be registered throughout Europe from 2035. The aim is also to make Germany the lead market for electromobility. No general speed limit will be introduced on motorways.

The key social policy points are the minimum wage of EUR12 per hour, improvements in the care sector and a citizen's income instead of Hartz IV (unemployment benefit) to secure subsistence. At the same time, affordable housing is to be created and the voting age

Co-CIO of Group Wealth Management and CIOUniCredit Bank AG (HypoVereinsbank) (Germany)

Philip Gisdakis

The goal is to build 400,000 new homes each year. A quarter of these are to be subsidised by the state.


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lowered to 16.However, it remains unclear how the necessary public investments will be financed, as the exploratory paper also states that there will be no tax increases and that the statutory debt brake will not be touched. The coalition partners will therefore have to be creative in terms of budgetary policy.

The distribution of ministries is equally unclear. There are already signs of a tug-of-war between the Greens and the FDP over the finance ministry, which is likely to play a key role in the large number of investment projects. In addition, there will also be differences to bridge regarding foreign and security policy. This applies, for example, to the NATO target for defence spending of 2% of GDP, the security of energy supplies (including Nord Stream 2), but also a common stance on deeper coordination of fiscal policy within the EU – including a discussed reform of the EU Growth and Stability Pact.

So, there are still some hurdles to be cleared before a government can be formed and a new chancellor elected. But this seems to be quite realistic until the Christmas break.


DisclaimerThis publication of UniCredit S.p.A., Cordusio SIM S.p.A., UniCredit Bank Austria AG, Schoellerbank AG and UniCredit Bank AG (hereinafter jointly referred to as the “UniCredit Group”) is addressed to an indistinct public of investors and is provided free of charge for information only. It does not constitute a personalized recommendation or consultancy activity by the UniCredit Group or, even less, offer to the public of any kind nor an invitation to buy or sell securities. UniCredit S.p.A., Cordusio SIM S.p.A., UniCredit Bank Austria AG, Schoellerbank AG, UniCredit Bank AG and the other companies of the UniCredit Group may have a specific interest in relation to the issuers, financial instruments or transactions that may be published, or have banking relations with the issuers themselves. Any estimates and/or assessments contained in this publication represent the independent opinion of the UniCredit Group and, like all the information contained therein, are given in good faith on the basis of the data available at the date of publication, taken from reliable sources, but having a purely indicative value and subject to change at any time after publication, on the completeness, correctness and truthfulness of which the UniCredit Group makes no guarantees and assumes no responsibility. Interested parties must therefore carry out their own investment assessments in a completely autonomous and independent manner, relying exclusively on their own considerations of the market conditions and the information available overall, also in line with their risk profile and economic situation.

It should also be noted that:

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2. If the investment is denominated in a currency other than the investor’s currency, the value of the investment can fluctuate strongly according to changes in exchange rates and have an undesirable effect on the profitability of the investment.

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