Monday Digest
Posted 9 September 2024
Nervous markets ahead of second pivot
Capital markets started September nervously, but our generally positive long-term view remains unchanged. China’s weakness continues to weigh on global growth: its corporate profit outlook worsened, as did demand for iron and steel. Beijing’s main support lever – stimulating production – is just worsening China’s inventory overhang and hurting global producers. Chinese exporters would have benefitted from US consumption (which has been resilient) in the past, but tariffs have broken that link and it could get worse if Trump is re-elected.
Manufacturing weakness is hurting carmakers in particular; Volkswagen said it might close German factories. Services sectors have at least stayed resilient, but markets worry that the downturn will spread. This is counter to investors’ narrative for much of 2024 – strong services leading a manufacturing recovery – and there is no clear contagion yet. Federal Reserve rate cuts should help, and we expect a 0.5 percentage point cut at the upcoming meeting. Tentative signs of service weakness challenge the ‘goldilocks’ environment investors hoped for, though.
That is why the Fed wants to cut rates. Despite the US’ prolonged outperformance, American employment and services inflation is weakening quicker than elsewhere. Granted, it is starting from a stronger point, but continued US exceptionalism isn’t guaranteed – especially after pandemic-era savings have been depleted. US losses would hurt global investors, but there could be positives for the global economy and markets too – like a weaker dollar.
Central bank meetings will dominate the next fortnight. The ECB comes first and is expected to deliver a 0.25 point cut, followed by the Fed with (hopefully) 0.5 and the BoE with nothing. A Fed cut of at least 0.25 points is all but guaranteed, after last week’s softish non-farm payroll data (142,000 jobs added in August, versus an expected 165,000). A bigger than expected rate cut can be scary: either people think the Fed knows some bad news we don’t, or they think the bank is behind the curve. But a more active Fed is a good protection and investors will surely take comfort in that.
August market returns review
August was a rollercoaster ride and, like an actual rollercoaster, it ended where it started. Extreme volatility early on gave way to a near flawless recovery and, in the end, flat global stock returns – 0.2% in sterling terms. Markets were initially worried about liquidity problems and US recession signals. Changing monetary policy at the Bank of Japan and US Federal Reserve unwound the yen ‘carry trade’ (borrowing cheaply in yen and holding it in higher-yielding dollars) which, along with tightness in China and US treasury markets, acted as a liquidity drain. Weak US jobs data amplified fears and volatility spiked, but the recovery was quick and unusually smooth mid-month.
Europe was the best performer, gaining 1.8% in sterling terms after bond markets moved to price in several interest rate cuts. Markets predict a shallower rate cut path in the UK, but Britain was still one of the best performers in August and the best over six months – up 12.5% – thanks to a steadily improving economy. China was again the laggard, dropping 1.9%. Its weakness also contributed to crude oil losing 7% through August. Chinese firms and consumers are not confident, and their desire to move money out of the currency probably contributed to gold reaching record highs.
US stocks recovered in aggregate but the tech sector dropped 1.5%. Without the biggest tech stocks, US equities performed similarly to Europe, suggesting an increase of market breadth across regions – and that big tech is a class of its own now. Japan couldn’t recover fully either, finishing 1.8% down, but that is impressive considering the early rout. The BoJ’s apparent capitulation to markets helped regain confidence, and our long-term view on Japan is positive. Despite the drama, August’s lasting impact will be central bankers turning more dovish – which should help the long-term picture.
What Türkiye tells us about the dynamics behind inflation
US Federal Reserve Chair Jay Powell recently said that inflation was beaten, thanks in part to the Fed. Some commentators questioned the self-congratulation – suggesting that temporary supply-demand imbalances could have worked themselves out without Fed interference. This is the longest standing debate in monetary theory – what effect does policy have? – and it is surprisingly difficult to answer because central banks are always reacting to what’s already happening.
So let’s look at an extreme case of unorthodox monetary policy: Türkiye. Its economic crisis since 2018 has seen the lira plummet and inflation skyrocket, during which time President Erdoğan has (until recently) preached his heterodox theory that high interest rates cause higher inflation. He has fired central bank heads who disagree, and economic policymakers have come and gone. This worsened Türkiye’s balance of payments, which suggests standard monetary theory is right (as does the fact that inflation is now coming down after Erdoğan allowed rates to rise).
But the story isn’t that neat: the timelines don’t match up and there are other explanations for Turkish hyperinflation, most notably the hugely damaging tariffs imposed by Donald Trump in 2018. Nobody doubts that Erdoğan contributed to Türkiye’s crisis, but that doesn’t necessarily mean his monetary policy is to blame. Many put it down to a general erosion of institutional stability, which is a problem if you want to argue Türkiye vindicates monetary thinking in developed markets with high institutional stability.
The Fed has a huge impact on markets, and markets have a huge impact on the economy – but it’s hard to untangle cause from effect the further along that chain you are. But we know expectations matter, so the Fed should act like its policy impacts inflation – even if they can’t conclusively show it. The question of what might have happened had the Fed not raised rates is hypothetical, and Türkiye shows that we should keep it that way.