Markets last week
Amid negative economic surprise indices globally and generally falling economic surveys and data, risk markets have continued to climb. Growth stocks, small-caps and in particular profitless tech have rallied very strongly since the market bottom on 16 June in the expectation of a pivot in Fed policy which has been anticipated by lower long-term bond yields. The yield curve (i.e. the difference between government bond yields of one maturity and another) has been pointing to at least an economic slowdown in the US, if not a recession. The 2- to 10-year yield curve is now inverted by 40 bps, a difference which hasn’t been seen since 2000. The reality, however, is that banks are still able to lend since their costs (which are closer to the 3-month yield) are still below longer-term yields, so the expectation of a recession in the US is probably premature.
The UK, however, is more likely to see an early recession, according to the Governor of the Bank of England (BoE), Andrew Bailey, who clearly stated that the UK was likely to fall into a recession later this year and remain there for all of next year. In addition to raising bank rates by 50 bps to 1.75%, the BoE forecast inflation topping 13% in October, a gloomy message which seemed to find little resonance among investors, with only a brief drop in sterling as a reaction.
Looking at the Q2 corporate reporting season, which is about three-quarters done, earnings growth is better than projected, but the bulk of the positive surprises is coming from the energy sector. Indeed, taking energy out of the reports, US earnings are down vs. last year’s comparable period and European earnings growth is considerably reduced.
Oil prices have taken a tumble recently, feeding into the hope that future inflation will fall sufficiently to trigger the expected change in central bank policy. This was the week, however, where no less than six US Federal Reserve (Fed) regional Presidents told markets in no uncertain terms that Fed policy on interest rates would continue unabated and yet there was little reaction from said markets.
Meanwhile, the BoE promised to keep hiking to bring inflation down, joining in the Fed’s chorus of uninterrupted rate hikes. The blowout July US employment report on Friday highlighted how difficult the Fed’s task remains, with inflation not likely to collapse as long as the jobs market is near record tightness levels. The numbers point to yet another outsize hike at the September Fed meeting, although there are still quite a few data points coming between now and then.
US House of Representatives speaker Nancy Pelosi’s trip to Taiwan and the Chinese military reaction stole the show last week, but did not really move markets that much, including Asian markets.
Against that backdrop, equities eked out another gain, though smaller than in recent weeks, with emerging markets doing best. A significant part of the gain for British and European investors was the strength of the US dollar. The best sector was technology and the worst energy, but defensive areas like utilities, healthcare and real estate also had a negative week. Government bond yields finished 15-20 bps higher on the week after the Friday employment data. The US dollar also recovered based on the strong jobs number. Gold rallied during the week, but its return was crimped by the higher yields on Friday. Oil prices dropped meaningfully to below US$95/bbl for Brent and below US$90/bbl for the US gauge WTI. The fall in crude has amounted to 20% over the last couple of months, leading to hopes that it will cool down inflation.
The week ahead
Tuesday: Chinese inflation
Our thoughts: once again, we will be amazed at how low inflation manages to stay in many Asian countries, with China in the headlights. A small increase from last month in the CPI (consumer price index) is expected, whereas a fall in the PPI (producer price index) is estimated. The latter matters much more to the rest of the world, given how many supply chains start in China. If the difference between PPI and CPI is reducing, it could be a good omen for future inflation numbers, with producer costs affecting consumer prices less.
Wednesday: US CPI (with PPI on Thursday)
Our thoughts: will US CPI inflation finally start to fall? This is now the market’s expectation, although it seems to be based on the recent drop in energy prices, since the core CPI ex food and energy is estimated to rise. The breakdown of price rises will be dissected by markets, looking for clues of a future downward path to inflation. The anticipation will be huge and investor reactions may be abrupt.
Friday: UK June economic data
Our thoughts: with the Governor of the BoE warning of a protracted recession in the UK starting later this year, the monthly growth data will be scoured through to find clues to the future direction of the British economy. Construction has generally helped UK growth, but the recent PMI drop may be an indicator of the sector rolling over. Of course, the services sector is still the largest in the British economy and its trend will be most important for markets.
The numbers for the week
Sources: FTSE, Canaccord Genuity Wealth Management
Central banks/fiscal policy
Gloomy forecast by BoE while Fed officials disagree with market’s views
The BoE’s Monetary Policy Committee made waves last week with the biggest interest-rate hike in 27 years and warned that the UK is heading for more than a year of recession. The 50 bp increase to 1.75% was followed by further comments on large moves again in the future. Governor Andrew Bailey said ‘The committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response. All options are on the table for our September meeting, and beyond that’, with the warning that a UK recession will begin in the fourth quarter and shrink the economy 2.1% in total.
The BoE also raised its forecast for the peak of inflation to 13.3% in October with price rises staying elevated throughout 2023. According to Deputy Governor Ben Broadbent, the energy shock hitting UK citizens’ incomes is about five times as bad as the worst episode of the 1970s.
The BoE also talked about its plans for quantitative tightening (sale of assets). Gilt sales are likely to start after a confirmation vote in September and will be around £10bn a quarter. Including redemptions, the BoE sees its stock of gilts declining around £80bn in the first year of the programme.
In the US, Federal Reserve (Fed) officials pushed back against the market’s view of a pivot away from tightening. San Francisco Fed President Mary Daly said the central bank was completely united to get inflation down (and she is a traditional dove), Cleveland’s Loretta Mester said she wants to see ‘very compelling evidence’ that month-to-month price increases are moderating, Chicago’s Charles Evans said year-end 2023 Fed Funds rate could near 4.00%, or 50 bps above market expectations, ultra-dove Minneapolis’ Neel Kashkari said it’s very unlikely that the Fed will cut rates next year, Richmond’s Thomas Barkin reinforced the hiking message and St. Louis’ James Bullard (admittedly a hawk) said he favours a strategy of “front-loading” big interest-rate hikes, and repeated he wants to end the year at 3.75% to 4%.
Also in the US, Congress passed revised version of the tax and climate bill (now called the Inflation Reduction Act, formerly Build Back Better), dropping a provision that would have narrowed a tax break for carried interest, altering a 15% minimum tax on corporations and adding a new 1% excise tax on stock buybacks. Large technology companies are likely to be the victims of the minimum tax and pharmaceutical firms will be targeted for direct negotiation on drug prices. The beneficiaries from this bill will be electric vehicles, renewables but also fossil fuels in a bid to provide a wider array of energy sources.
Blowout July jobs report confirms that the economy may be softening but employment is still ultra-tight
Employment: JOLTS job openings fell by 605K to 10.7 million in June, taking the March-June drop to a cumulative 1.2 million. The openings rate fell to 6.6% from 6.9% and down from a peak of 7.3% in March, but still well above the average of 4.5% pre-COVID-19. The quit rate, which measures voluntary job leavers as a share of total employment, remained unchanged at 2.8% in June. There are still 1.8 open jobs per available worker. The Challenger job cuts rose 36.5% year-on-year, down from 58.8%.
Initial jobless claims are rising slowly, now at 260K, vs. 254K last week, with continuing claims also up from 1368K to 1416K.
The monthly non-farm payrolls added a very strong 528K jobs to the US economy, much higher than expected, led by leisure and hospitality, professional and business services, education and health, with 471K of these new jobs coming from private payrolls and only a small number (30K) from manufacturing. Total non-farm employment is now back to pre-COVID-19 levels. The unemployment rate (U-3) fell to an almost record low of 3.5% from 3.6%, with the underemployment rate (U-6) remaining at 6.7% and the labour force participation rate falling from 62.2% to 62.1%. Worryingly, the average hourly earnings rose 0.5% during July, bringing the year-on-year growth to 5.2%.
Surveys: the ISM (Institute for Supply Management) manufacturing PMI was slightly easier at 52.8 vs. 53.0 previously. New orders fell from 49.2 to 48.0, but employment rose from 47.3 to 49.9. The biggest move, however, was in the prices paid index which dropped sharply from 78.5 to 60.0. This bodes well for future goods inflation.
The ISM nonmanufacturing PMI edged up to 56.7, against expectations of a drop. New orders were strong at 59.9. But the employment index (at 49.1) surprised on the downside again. As in the manufacturing PMI, the prices-paid index also continued its downward trend but remained high at 72.3.
Housing: mortgage rates dropped below 5% to the lowest level since early April. MBA mortgage applications were up 1.2% vs. a drop of 1.8% the prior week.
Industry: total vehicle sales, as per the Wards series, held steady at 13.35 million (annualised) from 13.0 million. Factory orders increased 2.0% in June, up from 1.8% the previous month, with the orders ex transportation also up a strong 1.4%.
Trade: the trade deficit narrowed from US$84.9bn to US$79.6bn in June.
Construction less buoyant even as housing is resilient
Industry: car registrations were down 9.0% in July year-on-year, better than the -24.3% the previous month.
Surveys: the construction PMI slumped from 52.6 to 48.9. Construction has been one of the most resilient parts of the British economy so far.
Housing: the Halifax house prices fell for the first time in a year in July. Prices fell 0.1%, which left the average value of a home at £293,221, still 11.8% higher than a year earlier. The Nationwide house price index rose 0.1% in July for an 11.0% year-on-year growth.
Bankruptcies: the number of companies filing for insolvency in England and Wales last quarter was the highest since 2009, at 5,629, an 81% increase on the same period last year.
Worse data throughout
Employment: the eurozone unemployment rate remained at 6.6% in June.
Inflation: the eurozone PPI (producer price index) rose 1.1% in June for a year-on-year increase of 35.8%, almost unchanged from the previous 36.2%.
Surveys: in Germany the construction PMI fell from 45.9 to 43.7.
Industry: German factory orders slumped 9.0% in June year-on-year, down from -3.2% the prior month. Also in Germany, industrial production rose 0.4% in June, up from -0.1%.
Consumer: eurozone retail sales fell 1.2% in June for a year-on-year drop of 3.7%, down from a positive growth the previous month.
Strong showing for Chinese exports but concerning surveys out of Japan
China: the unofficial Caixin services PMI rose from 54.5 to 55.5. Exports rose 18% year-on-year in July with imports up 7.4% for a trade balance of US$101.26bn, up from US$97.94bn. Foreign exchange reserves rose from US$3.07trn to US$3.10trn as a result.
Japan: vehicle sales fell 13.4% year-on-year in July, a little better than the -15.8% the previous month. The monetary base reduced from 3.9% year-on-year to 2.8% in July. Household spending rose 3.5% year-on-year in June, with labour cash earnings up 2.2%. The Leading Index CI eased from 101.2 to 100.6 whereas the Coincident Index rose sharply from 94.9 to 99.0. The Eco Watchers surveys, however, were very negative, with the current survey collapsing from 52.9 to 43.8 and the outlook falling from 47.6 to 42.8.
Not much help from OPEC+ but oil corrects
OPEC+ responded to months of diplomatic efforts from President Biden with one of the smallest oil output increases in its history. The cartel will add only 100,000 barrels a day of oil in September. Only the Saudis and the United Arab Emirates are able to bolster production, which means just a fraction of the amount is likely to be delivered. Their forecast is for the market to be in surplus by 800,000 bbls/day, hence they don’t see much need to up production.
Despite that backdrop, oil prices fell sharply both in the US and international gauges, although some of the drop was due to the futures rolling over at the end of June.
Gold slowly edged up to challenge the US$1,800/oz level again but fell back on Friday due to the strong US jobs data.