Monday digest
Posted 1 August 2022
Overview: positive market returns amid negative sentiment
For a second consecutive quarter, the US economy shrank in real terms. Yet the US Federal Reserve (Fed) raised interest rates by another 0.75% last Wednesday because the US economy is too strong. Yet, despite all of the bearishness, markets put in a stonking performance last week. Pretty much all equity and bond markets ended with asset prices at higher levels. In particular, corporate bonds did well, even in Europe. Given that much of the fear in markets revolves around a potential credit crunch through Europe’s winter, many commentators have seen this as probably only a temporary respite.
Europe is currently facing a worse outlook than other areas and much of the news worsened last week. Eurozone inflation for June was higher (marginally) than expected at 8.9% year-on-year. It will be even worse next month because energy prices just keep rising. After Gazprom came up with an excuse to not deliver as much natural gas to Germany as was promised, gas prices went up to new records. We are undoubtedly in a ‘cold’ war again. Europe’s plan to cut gas use by 15% until 2023 is important. But as of now, no concrete plans have been proposed by any country. We only know energy caps will focus the reduction on industry, and that households will not face cuts, even if they are not shielded from price rises. Until we see how businesses can be protected for this winter, investors will stay worried about the potential for unbearable costs.
Investors have been both bearish and uncertain for a long time, even though valuations on many assets have become substantially cheaper. When investor sentiment is poor, it can be quite difficult for markets to fall further without the news getting much worse. So, while there were stories which worried us, much of it told us essentially what we already knew (like the inflation data and the US GDP data) or had good reason to expect (such as the slow Russia gas supply). On the positive side, Jerome Powell sounded less hawkish than expected after the US interest rate rise. Meanwhile China’s politburo pressed for more support for their economy. A bull market isn’t likely to set in anytime soon and, almost certainly, not until the energy price squeeze dissipates. Nevertheless, at least last week, it felt like it wasn’t getting worse.
Reasons to trust in the Fed’s tinkering
As mentioned, last Wednesday the Fed furthered its monetary tightening agenda, pushing interest rates up another 0.75%, following the 0.5% rise in May and the first 0.75% bump in June. Capital markets expected as much, but the big news came from the post-meeting press conference, where Fed chair Jay Powell hinted at a change of tack. As the Fed continues to tighten policy, “it will likely become appropriate to slow the pace of increases”, he said.
That comment buoyed markets. Short-term bonds rallied and the S&P 500 gained 2.6% in Wednesday trading. The Nasdaq – dominated by America’s big tech companies highly sensitive to interest rates – gained 4.1%. Judging from these moves, the market consensus seems to be that the Fed will reaching ‘peak’ interest rates soon and likely cut them in less than a year. The Fed has good reason to do so, judging by the latest economic data. Demand has clearly slowed, and US GDP contracted in inflation-adjusted (‘real’) terms in the first half of this year, which would meet some people’s definition of a recession. Admittedly, Powell pre-emptively noted that, even if the US economy had been in a technical recession for the first half of this year, it would not be a contraction in any normal sense of the word. Even so, the economy is clearly slowing down. The big question for the Fed, and indeed all of us, is what this means for inflation.
In normal circumstances, it would be a no-brainer that slowing growth – let alone potential recession – would translate into slower price rises. But the current global stagflation is no normal circumstance. Sharp supply shortages need to be met with equally sharp demand contractions for prices to stay stable. And, with unemployment still at historically low levels, the Fed is concerned with stopping the damaging wage-price spiral above all else.
Even here though, signs look good. Inventory data on US retailers and wholesalers show a significant uptick in inventories. While retailers have a bit to go before their stock levels match pre-pandemic levels, wholesalers have higher inventory levels relative to trend than at any point in the last 30 years. On the flipside, retail inventories are significantly lower – the latter having come down from high points earlier in the year. This suggests that final consumer demand has fallen more sharply than expected, causing retailers to reduce their orders and leaving wholesalers with unwanted supply. That is bad news for them, but it points to a sharp reversal of the supply-demand imbalance seen last year.
One of the biggest sources of US inflation over the past couple of years has been the housing market, particularly outside of the big cities. This drove a strong period for residential construction, adding to the 2021 growth spurt and driving up lumber prices (an indicator of housing construction). In the past couple of weeks, lumber prices have taken a downturn. This suggests slowing activity which, considering the construction sector is a huge employer, will likely have big knock-on effects for overall inflation. Mortgage providers have been upping their borrowing rates and tightening lending standards for fear of recession and the dearth of payments that might bring. This suggests lenders think house prices are unsustainable in the current environment. Mortgage rates have fallen quite sharply in the past month but are still well above 5%. Residential construction will likely struggle to rally from here, putting downward pressure on both growth and inflation.
The Fed’s actions have undoubtedly contributed to these trends and will continue to do so. The problem is that monetary policy works on a long lag. Further tightening from this point will not bring down growth and inflation in the next couple of months but rather next year and beyond. If the futures markets are right, inflation is already set to come down quite sharply to a much more normal level by then. Any extra tightening the Fed does in that time will likely bring down future growth more than it will tame short-term price rises. Powell and his team are aware of this, and this is probably one of the main reasons their rhetoric is now moderating. This is not to say the Fed is done with rate rises, but that its aggressive stance has likely peaked.