Posted 27 February 2023
Overview: Balancing acts
Last week saw global equity markets give back some of February’s earlier gains. Even so, global equities have made a total return of around 5% in £-sterling terms since the start of the year. Over the past fortnight though, market participants have come to accept inflation – and in its wake interest rates – will stay higher for longer than previously anticipated. As a result, rising bond yields have been one factor pushing equity markets lower. Global risk assets tend to fare better when the US Dollar is in a bit of a decline, and that was the situation for November through to January. However, as February has progressed, the Dollar has strengthened. The biggest driver of the moves appears to be China, with weakness in the Renminbi. The surprise caused by the end of its zero- Covid policy generated optimism, but a bounce in the economy is taking longer than hoped. Activity may start getting stronger when spring arrives, but global metals and energy price falls are not a great sign.
Still, last week’s preliminary Purchasing Manager Index (PMI) data for January pointed to remarkable strength, especially within services. The resilience of households is striking, but not really surprising, given the buoyancy of jobs markets across the western industrialised world. In the US, seasonally adjusted initial claims (the weekly count of people applying for unemployment insurance) remained below 200,000. A normal level (when the job offers and seekers are in balance) is around 300,000. However, as we discussed last week, despite the tightness in labour markets there is a growing sense that inflation is not in any upward wage-price spiral. Consumption is being underpinned by the solid jobs markets, but not by household borrowing, nor by reducing savings. Spending growth is solid and sustainable rather than booming, and therefore unlikely to be overly inflationary.
To summarise, it looks as though the big threat to market valuations of a deep and sustained recessionary period – as anticipated at the market lows of last autumn – has passed and given way to a more moderate outlook. At the same time and against the backdrop of once again considerably elevated stock market valuations, this does not mean it is all plain sailing for investors. Nevertheless, as long as labour markets and with them consumer demand continue to be resilient – weakening global growth scenarios should only result in short-term volatility. Patience will once again be of the essence for the long term investor, while for their investment managers, continued scrutiny in assessing and identifying the relative winners and losers from the gradually unfolding scenarios will be the order of the day.
Inconclusive recession indicators leave markets guessing
Recession talk has been rife over the last year, with media commentators – and even some policymakers – suggesting investors and the public should brace for an upcoming global recession. These calls are backed up by many classic contraction signals: bond market upheaval, compressed business sentiment and mortgage credit stress depressing housing market activity. Contrary to this though, several key indicators are suggesting things are not so dire: employment is strong, consumer demand is resilient and equity valuations are still relatively high. With all these mixed signals, what should we make of recession chances?
One of the most well-known predictors of recession is the shape of the yield curve – the difference in maturity between long and short-term government bonds. In a healthy growing economy, the curve should slope upward, as investors expect a stronger economy in the future and therefore demand higher returns when lending over the long-term. By contrast, when investors expect the economy to be weaker in the future than it is now, the reverse happens. The US yield curve has inverted only a handful of times in the last half century. Every single one was followed by a recession. The US yield curve is currently inverted steeper than at any point since the 1980s, as short-term (three-month) deposit rates, and two-year government yields, are significantly higher than the 10-year yield on US Treasury bonds. But this does not mean a recession is guaranteed, much less imminent. For starters, the time lag between inversion and recession is long and variable, historically speaking. And in any case, the effects of rapid inflation and aggressive monetary tightening are severely distorting bond market dynamics. That makes classic signals like these much harder to interpret.
As another fairly reliable recession indicator, credit spreads do reliably spike before and during recessions. But interestingly, the highest credit spreads tend to come when a recession is already at its nadir, which if anything can be seen as a sign of recovery ahead. In fact, since the end of last year, credit spreads around the world have trended downwards. This suggests conditions are not immediately going to turn sour, and explains some of the more positive indicators we are seeing, such as relatively high equity valuations. So, we should take heart in the recent fallback in credit spreads. We are still on recession watch, but the alarms are not sounding just yet.
European gas prices
Britons are bracing for another energy price hike next month. The energy price guarantee – currently at £2,500 a month per household – will rise to £3,000 in March, unless the Treasury’s plans change, which seems unlikely, despite pressure from major industry players. The recent fallback in wholesale gas prices – which should give the Treasury some breathing room – will only have a “marginal” benefit to public finances, according to Chancellor Jeremy Hunt. That is debatable, depending on how you look at Government spending on the cap which will fall.
The market prices for natural gas are expected to continue to decline quite substantially. European natural gas recently became cheaper than at any point since the summer of 2021, six months before Russia’s invasion of Ukraine and the subsequent upheaval in international energy markets. Gas is still expensive by historical standards, but crucially, energy supplies – particularly those from Russia – are no longer the immediate threat to British and European economic stability that they seemed for much of last year. Analysis from Morgan Stanley suggests European gas consumption was 22% below the seasonal average in January. Even adjusting for the warmer weather, demand was 14% lower than would be expected at this time of year. The shortfall is not only big but growing too, down from a 10% weather-adjusted fall in December. Much of this seems due to a change in the energy mix, with a 20% increase in wind power generation.
Unfortunately for UK households, falling prices will take time to filter through. But it is only a matter of time, and the effect on budgets should be roughly proportional to the fall in wholesale prices. That means, should gas tumble by more than expected – as is very possible – bills should be lower too. For growth, inflation and for people more generally, that would be a welcome relief during the next cold season.