Markets largely stayed in a risk-off mode this week, as European inflation again surprised to the upside and long yields kept rising, UK markets went frenzy on the back of big spending plans, and geopolitical tensions expanded to the Baltic Sea region. We still think risks are skewed towards inflation becoming entrenched and central banks being forced to hike faster, raising the risk of a more protracted and deeper economic downturn, see our new macroeconomic forecasts (Big Picture – Chilling prospects for the global economy, 26 September). We also see more downside to EUR/USD which was closing in on our 12M forecast of 0.95 earlier in the week before recovering to 0.98 level. Weaker EUR is being driven by Europe’s ever-deepening energy crisis, looming recession and the associated underperformance of European assets. Geopolitics adds to downside risks.

On Tuesday morning, news broke that both Nord Stream 1 and 2 gas pipelines were leaking to the Baltic Sea. Nordic leaders quickly called the event a sabotage conducted by a government agent but have stopped short of blaming Russia as the investigations are ongoing. Market reaction was muted because flows were already at zero. Yet, the case was a sharp reminder of Europe’s vulnerabilities. Similar attacks against critical infrastructure such as gas pipes, LNG terminals or under-sea cables could have severe implications, and tensions keep building: the EU is currently working on the 8th round of sanctions against Russia as a response to their illegal annexation of four oblasts in Eastern Ukraine. Meanwhile, Russia continues to prop up its frontline with new recruits, likely in the number of much higher than the 300,000 initially communicated.

UK markets have been in turmoil after the new government announced a GBP 45bn unfunded tax cut plan last week, adding to the GBP 90bn already earmarked for households’ energy bills. As a response, sterling recorded fresh historical lows vs. the dollar on Monday while bond yields spiked. On Wednesday, the BOE was forced to intervene in the gilts market to prevent a liquidity crisis amongst local pension funds who were facing rising margin calls on the back of higher yields. Pressure is rising against the government to adjust their fiscal plans but thus far there are no signals of a policy reversal.

Next week, focus will remain on the quickly evolving security situation in Europe. Depending on Putin’s remarks in his speech on Friday the 30th, markets may either reflect a temporary relief or be spooked by further concerning signals. While Putin is widely expected to announce annexation of the four areas in Eastern Ukraine, a declaration of war is also a possibility and would mark an escalation. We highlight that while a frozen conflict in Ukraine and the extension of sanctions against Russia are fully priced in, escalation is not. Hence, any action by Russia, such as concrete hybrid or military attacks against other European countries, or the use of weapons of mass destruction in Ukraine, would likely lead to NATO’s intervention and trigger substantial negative market implications.

The calendar for next week is rather thin. We get the final manufacturing PMIs on Monday, and the service sector indices on Wednesday. ECB minutes are out on Thursday. The RBA will meet on Tuesday and it’s a close call between a 25bp and a 50bp hike. The RBNZ, in turn, is well priced for a 50bp hike on Wednesday. China is off the whole week.

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