Monday Digest

Posted 28 November 2022

Overview: Strength in weakness
Market sentiment seems to have improved significantly from one month ago. The release of the minutes from the Federal Open Markets Committee’s (FOMC, US central bank rate setters) 2nd November meeting offered documented evidence that members see a case for tempering its interest rate increases at future meetings. It is reasonably clear that recent declines in both actual inflation data and continued falls in the raw material cost inputs have changed perceptions of medium-term risks.

Moreover, despite the still-present potential for shock from the crypto-currency market, US retail investors appear to be heading back into the equity market. Government and corporate bonds have all recently gone up in price, although equity investors appear to be more positive about the future than bond investors. They expect earnings growth to either rebound next year or for the following years to be more profitable than usual. Perhaps investors have given up on the promise of fanciful riches from speculation in new currencies, and would rather invest in the more certain profits of companies. November retail volume flows have been the best in two years for small and mid-caps, according to JP Morgan’s flow data.

For us, one of the most interesting dynamics in capital markets this year has been the massive decline in corporate high-yield bond issuance. Given how fast and far yields rose, companies may be awaiting a better opportunity to issue debt, as investors are turning more optimistic and willing to buy at a yield that is significantly lower than seen two months ago. If and when issuance finally picks up, it will provide a real acid test and unveil whether lower junk bond yields have been the result of low issuance or a real sentiment shift towards a more optimistic 2023 outlook.

A last word on China, which we talked about last week in positive tones. While moving away from its ‘zero-Covid’ policy was inevitable, the transition was never likely to be smooth. Chinese authorities’ relentless past messaging about the dangers of the virus spreading may have been useful in gaining acceptance of the stringent lockdowns, but now those fears are a big impediment to opening up. It is going to be challenging, for sure, but nevertheless, there is no real alternative and so we expect China to gradually open up, even if that is interspersed by many renewed regional short-term lockdowns.

PMIs paint a gloomy picture for businesses
Regular readers will know that Purchaser Manager Indices (PMIs) surveys are important surveys of business sentiment. These surveys have been a surprisingly reliable indicator of future growth, where marks above 50 indicate expansion, and anything below that points to contraction. Across the latest PMI surveys for Europe and the US, companies are showing a high degree of pessimism. For November, every single European and American PMI we monitor came in below 50.

This is more confirmation, if any was needed, that times are tough. However, we should note that there was nevertheless a fair amount of good news in last week’s PMI releases, particularly coming from Europe. Economists expected the Eurozone PMI for the manufacturing sector would be again lower at 46, down 0.4 points from the previous month. In fact, European manufacturers posted a more upbeat reading of 47.3. Likewise, Europe’s services sector PMI came in at 48.6, matching last month’s reading and beating expectations of 48. The Eurozone’s composite figure beat both expectations and last month’s figure with a reading of 47.8. Clearly, these are not levels to get too excited about – they still point to a dreary picture in absolute terms. But they indicate a surprising amount of resilience from European businesses. That is hugely significant, given the overwhelming negativity on the continent.

The biggest surprise within the latest set of PMIs however, came from the US. Even though the US economy has slowed in recent months, economists expected only a mild decline. The November flash data was therefore quite worrisome: US PMIs came in well below expectations across the board, showing a sharp drop-off from last month. Manufacturing sentiment was expected to stay exactly neutral at 50, but instead came in at a decidedly downbeat 47.6. The predictions for the services sector were slightly worse at 48, but even that proved too optimistic, as US firms posted 46.1. It is difficult to make cross-country comparisons with the absolute figures, but even so, the fact that the aggregate reading for the US was below even struggling Germany is remarkable.

These PMIs suggest we may be entering a new phase of the global slowdown. Before, the focus was on hard input cost pressures and which region might be worst affected. Now, the problem may be more about employment and wage inflation and lagged effects of monetary tightening. While labour markets are tight around the world, the US jobs market is particularly tight, forcing the Fed to be more aggressive than most. This is perhaps a sign that the much-discussed ‘engineered recession’ could be upon us – to the relative benefit of Europe and the relative detriment of the US.

Continued labour market tightness keeps up pressure
Even with slowing growth and generally pessimistic outlooks from companies, labour shortages continue. This is a particular issue in the US, where wage pressures have stayed high despite aggressive monetary tightening from the Fed. US employers added 261,000 extra jobs in October alone, after similar figures over the previous two months. This may come as a surprise, given high-profile reports of job losses across key US industries. Tech giants like Amazon and Meta made headlines recently by announcing a wave of job cuts and hiring freezes. But these news stories are not a good guide to overall employment trends. First, tech sector job openings remain well above their pre-pandemic peak. And more importantly, the US mega-tech sector accounts for a rather small part of overall US employment.

Cyclical factors have contributed to the labour market squeeze. But the problem that policymakers now realise is that labour shortages appear to be structural. Over the past five years, governments (especially the UK and US) have moved towards tighter immigration controls, with the explicit aim of preventing employment competition for domestic workers. The result is a disconnect between what businesses and politicians say about jobs. We see this here in the UK, and the Confederation of British Industry (CBI) recently pleaded with Rishi Sunak’s government to ease migration controls, while policy continues to move in the opposite direction.

This creates a difficult situation for central banks, and especially the Fed. The FOMC minutes last week revealed most committee members expect to slow the pace of interest rate rises, and falling input price inflation backs this up. The next meeting is less than three weeks away, on 14th December. The underlying structure of the labour market is still such that wage-inflation could return quickly. Policymakers will be focused on the festive period ahead, to see how resilient consumer demand is. Anyone expecting the Fed or the Bank of England to ease off soon might be disappointed.


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