Monday digest

Posted 5 June 2023

Overview: markets take good news in their stride
In last Tuesday’s digest, we suggested that with the absence of any good news, markets were likely overreacting to the relatively low probability of a US debt default. As it turned out, last week, not only did we get a resolution to the US debt ceiling brinkmanship, but also the welcome news that inflation pressures across Europe were declining faster than expected, while the US jobs market remains paradoxically both vibrant and at the same time showing signs of slowing down (with unemployment going back up). Unsurprisingly stock markets staged a brief relief rally on the debt ceiling resolution, but began wobbling again when Chinese, US and European manufacturing sentiment data showed sure signs of contraction.

On the back of this, bond yields stopped their ascent and declined over the course of the week on the expectation that manufacturing headwinds should persuade central bankers to stop hiking rates. The extraordinarily robust US job market figures on Friday did not appear to change this narrative for bonds, while equities took the strong economic news as outright positive for a change. This came despite expectations for the first rate cut being yet again pushed out further into the future – now only expected for January 2024 (Back in January this year it was implied for the middle of the year).

There is little doubt in our minds that higher rates and higher yields for longer will leave more collateral damage in their wake. But in all, last week was a good one for the optimists, who may well believe equities look more attractive versus bonds again. As to the already seriously expensive US stock market, those same optimists might argue this is mainly driven by companies that will shape our society’s future, and therefore justify the hefty premium. Pessimists, however, will point to the higher-for-longer risks emanating from high interest rates and lending costs eventually driving down demand (and profits), causing a recession-triggering debt default cycle. They might also point out that US tech firms will have to generate almighty profits to justify current valuation hype. Optimists are holding sway just now, but whether it stays this way over the coming weeks remains uncertain. Stay tuned.

The Eurozone is still in an inflation fight
The good mood has excited some investors about Europe’s prospects. Inflation numbers are coming down even more quickly across the continent than had been expected. German inflation fell to 6.3% in May, below the forecast figure of 6.8% and substantially lower than the previous month’s 7.6%. France, meanwhile, saw annual price increases drop to a rate of 6%. For the Eurozone as a whole (6.1% year-on-year), inflation is back to levels seen at the beginning of last year. With some relief we can say that the worst of the European energy crisis is behind us, and surely not a moment too soon. Over time, this should also feed through into wider goods and services to help alleviate second-round price pressures. The European Central Bank (ECB) meeting last month delivered just a 0.25% hike, the smallest of this cycle and a signal that rates are approaching their peak. News that inflation is falling faster than expected increases these expectations, with some investors now predicting the ECB could stop raising rates as soon as July. In any case, the market is pricing in just another 50 basis points from here.

These are certainly encouraging signs, but we should not get ahead of ourselves. While falling energy prices should give the ECB confidence that there is not much more inflation to worry about in manufacturing, services, on the other hand, are showing much more persistent inflationary signs. Strong demand – a rebound from the winter cost-of-living contraction – has allowed service providers to up their prices, and higher wages are being passed on too. The wage factor is a particular concern for the ECB, which considers a cooled labour market the key to taming underlying inflationary pressures, over the long-term at least. In that respect, the signals policymakers really care about – the ‘sticky’ prices – are not as positive as one might imagine from the headline data. This is not to suggest the ECB will follow the BoE’s lead in nailing its hawkish colours to the mast, but merely to point out policymakers will probably be more cautious in believing the hype than some market participants. In particular, due to developments in services and wider labour market concerns, we expect the ECB therefore to sacrifice medium-term economic growth for the sake of continued inflation fighting.

UK’s housing market back under pressure
Britain’s housing market has fared reasonably well over the last year or so, all things considered. However, that resilience is being tested now. Figures released last week showed the number of homes sold in April was 25% lower than a year before, and 8% below the previous month’s figure. Rapid interest rate rises – and the fear of more ahead – are now clearly having a big impact. Earlier in the week, UK lenders pulled out of almost 800 mortgage deals. The number of residential mortgage deals fell by almost 7% in one week alone. Thin volumes often precede falling prices – sometimes sharply –  and fewer mortgage offerings dampen the outlook further, almost certainly reducing demand for residential property. So far, the housing market has managed to escape the gloom engulfing most other parts of the UK economy. This is unlikely to remain the case for long.

To make matters worse, it is likely that the impact of rate rises on the housing market will increase over the rest of the year. Around 1.8 million households need to re-mortgage this year, and the majority of those have not yet done so. It is possible some are hoping rates will come down – or at least moderate – as the UK economy worsens. But all the latest communications from the Bank of England suggest they are still extremely concerned about lingering inflation, and are prepared to raise rates further if need be. When those households do re-mortgage, they could find themselves in an even worse situation. Given improved mortgage criteria checks, this should not lead to widespread distressed sales, but it will absorb discretionary spending ability, which will hurt the wider economy.

Structural weaknesses in the UK’s housing supply prevent many building projects and means Britain’s ratio of homes to people is among the lowest in western Europe. This partially explains why prices have been able to grow so dramatically despite increasingly stretched affordability. But while structural imbalances may alleviate downward pressure on prices, they are hardly anything to be pleased about. Like many structural imbalances in the UK, they are ultimately a barrier to long-term prosperity and a sign of deep-rooted challenges. The housing market’s latest malaise is yet another example.

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