Monday digest
Posted 26 June 2023
Overview: Markets start catching up to reality
After weeks of calm, bad news returned and dented investor sentiment last week, with a mild sell-off reversing some of June’s gains. This coincided with a reversal of global liquidity as the US government sought to replenish its coffers and Pan-European business sentiment surveys ticked down. Hardest hit over the week were China (covered in more depth below), Europe and the UK (also explored below), but for different reasons. Moreover, Russia’s war with Ukraine took a bizarre turn over the weekend, following an apparent abandoned coup attempt against Vladimir Putin.
Looking back over the past year-and-a-half, Europe, the UK and (to a slightly lesser extent) the US have faced very similar input cost pressure from rising energy, food, and commodity prices. But now those price pressures have eased, some economists were predicting falling headline inflation leading to falling inflation expectations, lower wage settlements, continued sustained profitability and growth – and the avoidance of recession. Conversely, some economists have been warning that the second and third-round effects of inflation caused by the initial shock of goods and energy prices were feeding through and should not be underestimated. Last week’s UK data strengthened their case.
If the resolution to the inflation problem lies in overcoming a structural shortness of labour – and in the UK’s case free trade – central banks cannot solve it with what’s in their toolkit. For now, markets are giving politicians (and central banks) the benefit of the doubt, but fragile sentiment is easily disturbed by unwelcome news, as was the case over the past week.
The Bank of England is caught in a bind
Last week’s UK inflation report made for grim reading. May’s Consumer Price Index (CPI) level was 8.7% higher than a year ago, unchanged from April and the highest inflation reading of any G7 nation. It was yet another reminder, if anyone needed it, that the UK economy’s problems need urgent attention. Prices keep going up while growth prospects keep going down. That is horrible news for the Bank of England (BoE), which has been rapidly raising rates in fear of this exact scenario. It seems the dreaded wage-price spiral – where wages react to prices and vice versa in a vicious cycle – may be upon us.
Naturally, the news helped convince the BoE’s Monetary Policy Committee (MPC) that another 0.5% rise – taking rates to 5% – was the only course. But despite starting its rate hiking cycle earlier than most other central banks, accusations that the MPC is behind the curve on inflation – accusations that started late last year – are only growing louder. Worryingly, the BoE’s main tools for fighting inflation have proven ineffective. Bringing UK inflation under control cannot be achieved through rate rises alone. Supply-side changes are crucial, particularly for the post-Brexit era of an increasingly isolated labour and goods and services market. Productivity enhancements are a necessity, which requires improvement to infrastructure and public services. None of these factors are within the BoE’s control, and yet its 2% inflation target arguably cannot be achieved without them.
UK inflation is expected to come down as we go through the year, but economists now expect price increases to remain stubbornly high. Further rate rises are almost inevitable and, while offering no guarantee of short-term success in fighting inflation, they will squeeze everyone sensitive to borrowing conditions – from households and small businesses to the government itself. Given how important house prices are to the UK economy, through the so-called balance sheet effect, it is no surprise analysts are saying the BoE will have to engineer a recession before it can get prices under control.
The one potential upside to this story is that UK yields now look very attractive by international standards. This is not surprising given the inflation situation, but it could well mean that gilts start to capture interest from overseas investors. If so, there would be two distinct benefits: domestic fixed income investors get better returns, and UK bonds (as well as sterling) have a price floor. That is not a lot of upside, but it is at least something.
Investor disappointment in lacklustre China continues
Expectations of a post-Covid boom for the Chinese economy have decisively fizzled out. The world’s second-largest economy recently recorded below-estimate figures for retail sales growth, industrial production and fixed asset investment, while youth unemployment rose to a record 20.8% in May. For investors, the prevailing opinion is that markets got ahead of themselves, with sentiment turning decisively since April. China’s benchmark stock index, the CSI 300 is now just flat (-0.2%) for the year, while Hong Kong’s Hang Seng index has fallen 4.5% over the same period.
Low confidence is a huge factor wherever you look in China. Consumer sentiment undoubtedly improved following the end of the psychologically-damaging zero-Covid policy, but those improvements have since tapered off. Overall employment levels are holding steady, but the increase in youth unemployment has been surprising. Moreover, this does not look like a short-term cyclical problem: there is arguably a skills mismatch between young Chinese – who are more highly educated than any previous generation – and jobs on offer which are focused more in lower-paid or lower-skilled areas.
The People’s Bank of China responded to the youth unemployment figures by cutting its medium-term lending rate. This policy responsiveness is what markets are hoping for, but many worry it will not be enough and rumours of further policy support have failed to materialise. While growth is a priority for President Xi Jinping, it is clearly not the only priority, and the ‘top brass ‘is hesitant to overreact for what could be a short-term blip. The danger is that this long-term thinking starts to look like unwillingness – or worse, inability – to deal with the problems at hand. The property sector troubles are arguably one such case. The problems have been clear for some time, and yet long-term solutions are still lacking.
From our perspective, the most interesting part of all this is how disconnected China has now become from western economic cycles. That is both good news and bad news: it means greater opportunities for diversification, but we can no longer expect China to pick up the slack from the west either.