Monday digest

Posted 10 July 2023

Overview Markets sour on news of resilient economy

The second quarter’s positive stock market returns were driven by a somewhat surprising improvement in investor sentiment. At the end of March the fear was that the US regional banks crisis would create a more pronounced slowdown than previously anticipated, which it did not and also while bond yields rose, analyst forecasts of corporate profits did not anticipate anything more serious than a period of stagnant growth.

Markets look to have abandoned this narrative. Positive US job growth figures have been blamed for a reversal in sentiment, with equity and bond markets having fallen and bond yields having risen. So why have investors shifted their views so suddenly to the downside?

The change we experienced over this week was one of sentiment towards the future cost of capital. Up until the end of June, there was a growing expectation that at least the US central bank, the Federal Reserve, was at least close to ending their rate hiking cycle and that cost of capital as a result would not rise further and indeed was likely to start to fall over the coming 6-12 months.

Particularly hawkish statements from the Fed began to challenge these expectations. This week’s data flow of continued tightness of the US labour markets provided more evidence that the Fed may not be done with raising rates, meaning that the other central banks who were expected to be following the Fed, would end their rate rises even later.

So, in summary not particularly much has changed on the hard data front over the past few days, but a surprisingly strong US labour market report disturbed the fragile market balance. Whether this return of ‘good economic news is bad news for market valuations’ is enough to sour sentiment more permanently, remains to be seen. A second set of labour market data on Friday presented much less of an upward outlier, however, confirmed that the US labour market shows no signs of imminent turning.

A higher cost of capital can more easily be absorbed and carried by the economy when accompanied by decent growth and good levels of monetary liquidity – both of which remain broadly in place at the moment. This means markets should continue to carry a higher probability of trading sideways than down over the summer. However, if the other effect of this economic resilience is a slowing or reversal of the recent steady decline in inflationary pressure from the input cost side then the central banks raise rates ever higher. For the time being positive sentiment may well prevail, but for markets to remain that way, this week’s data flow needs to show an environment, where services gradually start to follow the manufacturing sector into an economic soft patch.

Global Inflation Update

Last month’s Federal Reserve meeting was perplexing.  Due to persistent inflationary pressures, the Fed intimated that it will likely need to raise rates two more times over the coming months, despite pausing for the time being. Markets had previously hoped for just one more hike, after which financial conditions might ease – but any easing in rates will not come until 2024 at the earliest.

The Fed defended this stance on the basis that the US economy and financial system will need time to settle, and that inflationary pressures persist. This makes some sense given the upheaval witnessed in US markets over the last year  – major US regional banks collapsing sent shockwaves across the financial system. While these considerations counsel against tightening too hard – and causing an unnecessarily painful recession – they do not negate the fact that the world’s largest economy is still running hot.

The Fed also published updated forecasts for core inflation, showing prices are expected to remain stubbornly high for some time. Officials now think core US inflation – currently at 4.7% – will fall to 3.9% by the end of this year. This is a much slower decline than forecast back in March and implies the Fed does not expect to reach its 2% target for another two years, or it expects other factors – like input prices – to offset core price rises over that period.

However, some capital market research institutions believe that the US inflation rate could fall faster than the Fed’s predictions, and there is also a clear downward trajectory in real consumer spending and shortages seen in the US labour market look set to find a balance. 

Over the past year, central banks have been extremely concerned about the impact of input-cost inflation. The most prominent is the dreaded wage-price spiral, but in the US – as in Europe- we are seeing tentative signs of wage moderation.

A year ago, persistently high inflation was causing people to demand higher pay, signals which fed back through into price setting in a worrisome loop. Now, with more stable longer-term horizons,  wage pressure has eased, helped by a dramatic easing of supply chain problems, but we should not get ahead of ourselves. Inflation is steadily falling around the world but it is dangerous to assume this trend can continue unchallenged. External supply shocks, a fact of life over the past few years, are always possible. 

This was the lesson learnt from the period of stagflation seen in the 1970s: what might seem like simple supply-side shocks can have lasting consequences on how people react to changes in supply in the future. Central banks seem keenly aware of this prospect. The ECB’s latest inflation forecasts are above target until 2025, with core inflation being similarly long-lasting.

While supply chain issues have certainly eased, we are already in a phase of supply contraction. Crucially, this is happening both at the source of production and further along the supply chain in the stocks of intermediaries.

A leaner supply chain and a run-down of inventories is perhaps the natural reaction to weak global demand, but it makes the global economy more vulnerable to supply shocks. It could also mean that the fallback seen in input prices could soon be coming to an end. If global growth stays steady, we may see renewed input price pressures before too long. Headline inflation is still falling thankfully, but we should be cautious about how long this can last.