Tuesday digest

Posted 30 August 2022

Resolute Fed leaves markets in a delicate equilibrium

All eyes were on the annual Jackson Hole conference last week, where mildly hawkish US Federal Reserve (Fed) chair Jay Powell declared it “must keep at it until the job is done”, repeating his emphasis on controlling inflation and cooling wage demands. This has made investors nervous. Equities rallied last month on the back of improved valuation metrics, but bond market positivity was in large part down to expectations of a less hawkish stance. We suspect that this year’s downward stock market volatility has led to a delicate equilibrium between the negative impact on earnings and the positive reaction that could come from central banks. Should the Fed prove successful in engineering an inflation-busting slowdown in the labour market without an economic crash landing, there will be less upward pressure on bonds. ‘Delicate’ is the key word here.

Consumer and now also business confidence has taken a downturn, signalling a slowdown in growth, particularly in the US. But despite the gloom, profit margins have held up nicely across the Atlantic. In fact, recent data shows US corporate profit margins expanding to their best ever ‘book profit’ level in the second quarter of 2022. Cash flow is still remarkably strong, giving companies a buffer for the difficult times ahead. Particularly interesting is what this means for different investment styles. So called ‘growth’ stocks, like big tech companies, are usually heavily dependent on bond yields, as they are long-duration assets and therefore sensitive to assessments of long-term risk premia. But bond yields are clearly no longer the only driving factor behind these stocks. The biggest names – Amazon, Netflix, Microsoft and Apple, to name a few – have unquestionably come of age and are now by far the biggest players in their respective sectors. This means that their growth is not so much at the expense of old businesses, but rather a reflection of the market as a whole. Being exposed to the ups and downs of the economic cycle creates new dynamics and new avenues for growth and investment returns. For the discerning investor, this delicate equilibrium could be full of opportunities.

Strategies needed to mitigate Europe’s energy crisis
Closer to home, the UK was hit by the latest news of a near doubling of Ofgem’s energy price cap for the winter months. The arrival of a new prime minister must surely bring more government support for households. Even with government help, households will inevitably struggle, but businesses are under threat too. There is no price cap for businesses, meaning energy costs have increased several times over. Providing support for those businesses – particularly small and medium sized enterprises – is imperative in the months ahead. This is akin to the situation at the start of the pandemic: without help, small businesses will have to shed staff or face total collapse.

Heading into the winter, the energy outlook is harsh across all of Europe. Policymakers have discussed rationing and power outages at length, but there are no coordinated plans yet. In lieu of central edicts, the market is left to do its own energy rationing – as firms or consumers get priced out. Politicians have been quick to signal their support for households in all of this, but help for businesses has been less forthcoming. All across Europe, businesses face worsening conditions. Sales have already slowed somewhat, and inventories of goods have risen. Europe may already be in a recession and business sentiment surveys now firmly point toward contraction in the second half of 2022, while corporate debt is showing severe signs of stress. If politicians want to avoid a harsh economic winter, their options are limited. For now, it looks likely that Putin will keep using gas supply as a weapon in his hybrid warfare.

Business sentiment takes another battering
August’s sentiment surveys of consumers and businesses paint a rather unpleasant picture for the world economy. Consumers everywhere are not confident and have not been so for some months. This is particularly true in the EU, where confidence measures continue to languish near or at record lows. For the UK, July’s GfK consumer confidence survey hit a new record low of -44. Business confidence surveys, in the form of the Purchasing Managers’ Indices (PMIs), are even more timely than the consumer confidence data. Last week’s flash data for August across developed markets showed the ‘all-industry’ or composite PMI fall to 47.3. Relative to manufacturing, service industry confidence had been holding up relatively well in the first half of 2022, but the August service PMI data was notably weaker than expected. On the other hand, through the past month data sourced from actual activity has kept relatively robust. In Germany, consumer spending is holding up despite the constant depressing news flow. Importantly, jobs are still secure. Firms seldom make significant staff changes in the summer months, partly because doing so takes a lot of management effort. Last week’s PMI data did not include China, as its data collectors do not publish flash estimates. Instead, they wait for the full release which will arrive in the first days of September. Last month, China’s service PMI data improved sharply and, given the flash PMI weakness of so many other areas, it will be hoped such resilience can be maintained. PMIs have been signalling a deteriorating environment for the past three months. That has worsened with this month’s output and new orders PMI data. As we emerge from a long hot summer, we are hoping employment remains resilient, but not as overly tight as it has been. Hopefully the future output data will signal a stabilisation of confidence for both consumers and businesses.