Monday digest
Posted 7 November 2022
Overview: divergent paths and scary season messages
Considering the gloomy news from the US and UK central banks last week, investors enjoyed a decent enough start to November. In the UK, the 0.75% rate rise from the Bank of England (BoE) came as no surprise, but Governor Andrew Bailey delivered a dovish outlook, suggesting interest rates would likely not have to rise as high as markets had anticipated and therefore that mortgage rates can be expected to come down from their current heights. This guidance was enough to send sterling lower, even as prospective UK home buyers will have sighed with relief.
Elsewhere, persistent rumours about an end to China’s zero-COVID policy had gotten investors very excited, and led to a 10% rebound in Hong Kong’s stock market during the week. This reminded us of the strong market rally that accompanied the post-COVID re-opening phase in Europe and the US in the Spring of last year. This positive momentum had already spilled over to European markets, further buoyed by better than expected (or less bad) corporate earnings numbers. But half-way through this quarter’s corporate earnings announcements, and after subtracting the gushing profits from the energy sector, it must be acknowledged that the global picture confirms that recent worldwide economic weakness has hit earnings and will continue hitting revenues through the next few months at least. While not great news in terms of that fundamental underpinning of stock markets, this undeniable sign of slowing activity also tells investors the drivers of persistent inflation are abating, and with them the pressure on central banks for more tightening.
This would explain the diverging central bank messaging. In the US, the economy and jobs market have proved resilient enough to keep the Fed determined to apply the interest rate brake. Meanwhile, across Europe and the UK, household’s higher energy and mortgage expenditures are increasingly seen as potentially destroying more discretionary demand than may be necessary to bring inflation back under control. This divergence of central bank policy makes forward market assessments ever harder, as the effect is likely to keep the US dollar on its upward trajectory, or at least stronger for longer. At the same time, the prospect of a return of Chinese consumers to the global demand equation has to be an overall positive, even if oil prices rose in the wake of the good news.
The coming months are going to be tough for the global economy, as central banks raise rates incrementally and energy prices remain too high. New data releases may generate temporary market sentiment upswings, but as long as the weaker growth picture is accompanied by inflation driven by more than just higher energy costs, it may take some time – or a mild winter – before we are out of the proverbial woods.
The Fed’s not for pivoting
Another month, another jumbo rate rise in the US. As fully expected, last Wednesday, the US Federal Reserve (Fed) increased its benchmark funds rate by 0.75%, following an equal hike in September. Equities initially strengthened by more than 1%, but at the end of Wednesday’s trading session, US Treasury yields had risen sharply, and equities were down, with the S&P 500 off 2% by the close. That initial burst of optimism was undone by Fed Chair Jerome Powell, who delivered more pugnacious rhetoric than the initial announcement had suggested. His stance is likely to tilt the balance for the next couple of Federal Open Market Committee meetings, keeping the Fed hawkish despite the statement’s seemingly more positive pivot.
US interest rates are now between 3.75%-4.0%, having been at zero as recently as March. At the same time, rates are still well below current year-on-year inflation figures. September’s Consumer Price Inflation (CPI) reading came in at 8.2%, meaning the purchasing power of savings is still being eroded significantly. To make matters worse, cost pressures appear to have slowed only a little since the Fed’s last meeting. Data released since then have shown broad price increases across goods and services. Moreover, the supply side of labour remains tight – US unemployment is still extremely low and job openings have been increasing again in recent weeks.
Despite the FOMC’s tough talk, bond markets have a pretty rosy view about the future of Fed policy. Most investors currently expect the Fed to raise rates by a smaller 0.5% at the 14 December meeting and a majority now expect the same on 1 February. This will put rates up to 5.0%, the expected peak. In fact, current market expectations are that the Fed will cut interest rates as early as next September, having achieved the slowdown and got inflation under control. This is quite the vote of confidence in the Fed’s ability, and one it may find difficult to live up to.
Are things looking up for European stock markets?
Europe has been of the weakest parts of the global economy this year. Seen as suffering more than other regions from supply-side disruption, particularly energy of late, corporate credit spreads (the difference between government and corporate bond yields) have widened dramatically, while equity values have substantially underperformed.
That said, some European countries, like Spain, have actually held up well, despite regional pressures. The regional variation is mostly to do with the sectoral makeup of different European markets. The energy supply crisis has been profitable for many energy companies, with increased pricing power leading to some huge windfall earnings. Of course, even within the energy sector there are disparate results. Many have struggled, a fact highlighted by the German government’s recent nationalisation of Uniper SE, its largest gas importer. On the other hand, utilities providers specialising in renewable energy – such as Spain’s Iberdrola – have fared very well. Indeed, record profits have been a topic of intense political debate, pushing governments to enact ‘windfall taxes’. This political pressure remains one of the reasons why valuations have fallen so sharply in the sector. Despite good times right now, investors are sceptical about long-term prospects for many energy companies.
The flipside is that energy pressures have substantially decreased in the last couple of months. Gas prices, though still high, have come down from the previous peak. This suggests Europe may be over the worst of its crisis, which is tentatively reflected in recent market moves. But even with the recent turnaround in commodity prices, investors are not getting too excited about the continent’s prospects. One need look no further than the UK to see why. While Britain’s performance has diverged significantly from the rest of Europe in recent years, it still serves as a cautionary tale.
Still, things are not all bad. With commodity prices receding, the hope is that spots of outperformance will be backed up by a general turnaround. Markets will take some convincing but, given how expensive US assets have become on a relative basis, there is certainly the potential to pick up some bargains in Europe. This is especially so considering the divergence between different countries and their sectors. Underneath the grim headlines, Europe is as heterogeneous as ever.