Markets last week
After two dreadful weeks previously, the last few days have been something of a relief. Perversely, it was bad economic news that drove the change in direction – that and a very oversold position in many assets. From the worries about inflation and the pace of central banks’ reaction to it that saw interest rate rises in the US and the UK and even an emergency ECB Council meeting to try to bolster the eurozone’s response to soaring CPI data and collapsing bond markets in the peripheral European economies, the focus moved to the increasing likelihood of the combination of rising prices and aggressive central banks driving the world economy, and even the mighty US, into recession.
As a result, the pressure on equities from higher bond yields has, at least for a time, abated. After a brutal few weeks, it is no surprise to see some short-term bounce, and now we have officially moved into bear market territory in the US, bear market rallies are to be expected. These tend to be both relatively sharp and also disappointing, in that they generally evaporate, as in the words of the Ukrainian national anthem, like dew in the sun.
Sensible investors have long looked forward to a more “normal” environment, where markets can operate free from the sugar rush of zero or even negative interest rates. Most had hoped that the progression from where we have all been since the global financial crisis would be orderly. But nobody could have foreseen the current state of affairs with rampant inflation and a war in Europe. Getting to “normal” is going to be hard, especially with inflation at its highest for forty years in the UK.
But last week at least was a calmer one.
In fixed interest markets, US ten-year government bond yields fell from a recent peak of around 3.5% down closer to 3.1%, although we should be under no illusions that the recent change in trend to upwards momentum has changed. There were similar drops in yields in the UK, from 2.5% to 2.3% and in Germany from 1.7% to 1.4%.
Equities responded, with most major indices in the blue and rises of 2-4% common across the board.
US equities climbed the most, by 6.4%; the UK went up by 2.4%, Europe by 2.8% and Japan by 1.7%. Chinese equities were also strong, as the recent recovery is aided by policy easing and reducing short-term worries over regulation of the important technology sector there. The equity rally was broad-based, although the oil and gas sector – still by far and a way the best sector over the last twelve months – failed to participate, falling 1.6% as crude oil remained subdued – although well over US$100/barrel.
Commodity markets sat on the side lines as both equity and bond prices enjoyed the recently unusual experience of going up. Gold was at US$1,827/oz, with industrial metals like copper weaker and oil in the doldrums, flat for Brent crude and down 1.8% to US$107/barrel for the WTI blend.
In currency markets, the dollar stayed steady at the very high levels it has reached over the last year and more. At the end of the week sterling against the dollar stood at US$1.23 and against the euro at €1.16.
The week ahead
Summitry all week: the G7 in Germany early in the week and NATO in Spain later
Our thoughts: the focus in the G7 summit will be on food security, measures to tackle the energy crisis, inflation, and of course, the war in Ukraine. Achieving consensus on economic measures to combat inflation will prove difficult, as conflicting special interests in the G7 economies make rapid progress unlikely. Within NATO, maintaining a united front in the face of Russian aggression should be possible, even if there are cracks beneath the surface between the hard liners like the UK and those more open to realpolitik and pushing more overtly for negotiations and their inevitable compromises.
Thursday: Personal Consumption Expenditures (PCE) data in the US
Our thoughts: PCE is the Fed’s favoured measure of inflation, and has shown signs previously of rolling over, with the more important core measure last marked at 4.9% down from a peak of 5.3% some months ago. Any indications that this progress has stalled or gone into reverse would be seen negatively by equity markets, with consensus expecting a further small decline to 4.8%. With a 0.5% increase in US rates at the July Fed meeting now fully discounted, a bad number would encourage those who feel another 0.75% may be in the offing, similar to last week’s move. The position is made more complicated because the wider measure, which includes food and energy prices, is expected to go up to 6.7% from 6.3%.
Friday: US Institute for Supply Management (ISM) purchasing managers’ data
Our thoughts: the important ISM data will be scanned carefully for signs that the American economy is decelerating further and faster than already expected. We highlighted last week how, after a negative GDP reading for Q1 (after a blow-out Q4 2021 print), there are already some pointers showing that the economy is at stall speed right now, so signs of weakness may presage a technical recession already (two consecutive quarters of negative growth). Other recent forward looking data point in the direction of a drop in reported activity. Perversely, a particularly poor reading might not be taken so badly by markets as, in the present “bad news for the economy is good news for equities” mood, it might be seen as reducing pressure for higher interest rates and be supportive of bond markets. The consensus forecast for the headline number is for a fall from 56.1 last time to 55.0, although attention will focus on the prices paid component, which is exceptionally high right now at 82.2 and is expected to rise still further to 83.0 this time.
The numbers for the week
Sources: FTSE, Canaccord Genuity Wealth Management
Central banks/fiscal policy
Talking the talk
After a week of hyperactivity from the world’s central banks, the move was towards talking, not walking. Most prominently, US Federal Reserve chair Jerome Powell gave a day each of testimony to the Senate Banking and to the House Financial Services Committees respectively.
Powell stressed that achieving a so-called soft landing was possible, although increasingly difficult, blaming mainly external factors for the difficulties in which the Fed finds itself. He gave a hawkish tone with regards to the primacy of getting inflation under control, stressed the strength of the US labour market and made clear that the direction of travel for US rates remained firmly upwards, with a 0.5% increase pretty much baked into the cake for July. Now that the Fed’s own forecasts for the trajectory of rates are aligned with market expectations, there is at least some room for downside surprise on expectations, whereas previously there was none.
The hawkish tone to both houses of congress helped markets take a pause from their earlier rout, as now recession fears provide some counterweight to the previous overriding spotlight on inflation.
Elsewhere in the world, a whole raft of central bankers gave speeches, the vast majority of which focused on price pressures on the economy and gave little comfort to any seeking relief from tighter monetary policy.
Further evidence of a decelerating economy
Fed bank stress tests: The Fed gave the green light to the banking sector to return several tens of billion dollars of excess capital to shareholders as all major companies in the sector passed the stress tests, which war gamed a sharp fall in asset markets and a collapse in the housing market (see below). The ability of the sector to weather these theoretical outcomes illustrates starkly one of the unusual features of what looks like a pending recession in the US: after all the prudential measures put in places following the global financial crisis, the banking system is extremely well capitalised, an unusual, but comforting place to start an economic downturn.
Surveys: The Chicago Fed survey gave more evidence of slowdown, with a reading of 0.01 compared with 0.40 previously. It’s Kansas City counterpart’s compositive activity index fell to 12 from 23 and its manufacturing index slumped to -1 from +19. The Michigan Consumer Sentiment index fell to 50.0 from 58.4, with the expectations component fall still more steeply, to 47.5 from 55.2. Meanwhile, the five-year inflation expectations index published at the same time crept higher to 3.1% from 3.0%. The embedding of incrementally higher inflationary expectations into consumer mindsets is precisely the kind of behaviour likely to keep central bankers hawkish.
Housing: Existing home sales showed a decline of 3.4% in May, a deterioration from the -2.4% seen in the previous month. The slowdown in the residential market was further underscored by weak mortgage applications, on a declining trend even if showing 4.2% growth year-on-year (the equivalent was +6.6% in the previous month) and declining mortgage refinance activity, with the index now approaching lows last seen over a decade ago. This drop is scarcely surprising when the rise in 30-year mortgage rates to a whisper beneath 6% is taken into account – only last month the rate was 5.65%. This negative data was offset to a minor extent by rather better new homes sales data for May, although this is a volatile series and now rather historic.
Industry: The S&P Global (formerly Markit) PMI data showed marked declines. Manufacturing fell to 52.4 from 57.0, services to 51.6 from 53.4 and the composite to 51.2 from 53.6; clear signs of falling economic momentum.
Employment: there was little movement in the jobless data, with initial jobless claims flat at 229K, roughly the same as the previous week at a revised 231K with continuing claims continuing to edge up from 1310K to 1315K.
Baker Hughes rig count: in a clear sign that high oil prices are encouraging increased exploration activity, the Baker Hughes drilling rig count rose to 753 from 740. This gauge has been on a very steadily rising trend for 18 months now, even if it remains well below the previous pre-pandemic peak.
A generally weaker tone
Inflation: with the BoE openly forecasting a peak of around 11% in the CPI measure of inflation later in the year, it was no real surprise to see a print for May of 9.1%, unwelcome though it was. There was a glimmer of better news in that the core rate, which excludes food and energy, rose by “only” 5.9%, down from 6.2% previously.
Industry: The S&P Global PMI data showed slowing activity, with manufacturing at 53.4 compared with 54.6 the last time, service flat at 53.4, leaving the composite measure also flat, showing the relatively small part manufacturing takes in the wider UK economy.
Surveys: the CBI industrial trends survey fell to 18 from 26, whilst retail sales data remained weak, with a reading of -4.7%. Although this was slightly less bad than the previous reading of -5.7%, it should be seen in the context of high levels of inflation.
Fewer signs of stabilisation in economic activity this week, with PMI data poor
Surveys: although French business confidence managed to increase slightly over the month, to 108 from 106, the much-watched IFO survey in Germany dropped to 92.3 from 93.0, with the forward-looking expectations component especially weak at 85.8, down from an already low 86.9.
Industry: the S&P Global PMI surveys were almost universally weak: In France the manufacturing survey fell to 51.0 from 54.6 with the equivalent in Germany declining to 52.0 from 54.8. Further declines are to be expected as Russia puts the squeeze on German industrial gas supplies.
Inflation: In an eye-watering data release early in the week, Germany announced that producer price inflation (PPI) for May had come to 33.6% year-on-year. Although this was only slightly higher than the previous month, it certainly underscores the challenges facing companies in managing their costs and policy makers in managing interest rates.
Japan ploughs a different furrow
China: no meaningful data.
Japan: In contrast with much of the rest of the developed world, the Jibun PMI data from Japan showed broad resilience to the slowdown elsewhere. The manufacturing measure did fall to 52.7 from 53.3, but the services element rose to 54.2 from 52.6, leaving the composite gauge up at 53.2 from 52.3. Meanwhile, core inflation data printed at 2.1% year-on-year, unchanged on the month. Japan doesn’t have a problem with inflation, quite the opposite. It says something that with a much weaker yen and huge rises in imported energy costs, Japan can still only just beat its long-term inflation target of 2%.
A quieter week after the fireworks last time round
Oil drifted slightly lower over the week, although compared with the very sharp falls the previous period, this was a relatively steady performance. Gold also drifted marginally lower, but copper was notably weak as investors worried about the impact of a potential recession on demand.
At a time when developed markets are suffering from the highest level of inflation for generation, it shows how times have changed that South Africa, which is a perennial inflation bad boy, published its most recent inflation numbers with a core rate of 6.5%, very similar to the US and the UK. There are very few places to hide from the scourge of rising prices.