Posted 29 August 2023
Overview: Growth divergence between Europe and the US widens
After a global bond sell-off over the last few weeks that drove up bond yields they ended last week lower due to unexpectedly weak business sentiment reported through the ‘flash’ Purchasing Manager Indices (PMI) survey results. While the worst figures come in from the services sector in Europe and the UK, the US services PMI at 51.0 was also weaker than expected but still managed to remain above the neutral 50 level. Indeed, recent US data may have felt mixed but the combination indicators suggest growth is solid to strong.
Some of the divergence can be traced back to energy prices still remaining more of a burden for Europe’s manufacturers, especially for natural gas and electricity. Sentiment improved through the first half of this year as gas prices declined but the recent uptick in both oil and gas prices is a blow. Meanwhile, the auto sector (much more important in Europe than the US) is also feeling a sharp pinch, with Chinese electric vehicle manufacturers gaining substantial market share at home and getting an easier ride in Europe than in the US.
Economic divergence between regions is not unusual, and Europe is prone to having bouts such as the euro crisis. We don’t think something as serious as that is about to happen, but there is little doubting that Europe has less resilience than the US currently, due to the conspicuous lack of growth momentum. This probably means pressure on the US dollar to strengthen at least for a time and, historically, that has coincided with increased global risks. Over the weekend, central bankers were gathered in Wyoming’s Jackson Hole, focusing their attention on longer-term “Structural Shifts in the Global Economy”. Our hope the meeting would bring more clarity on how central banks view their current policy options was somewhat disappointed, although markets took the relative calm of central bankers as a sign that we have or are close to ‘peak rates’.
EU and UK both shocked by disappointing sentiment surveys
We wrote last week that, after being the best performing currency of the year so far, sterling looked vulnerable. As if like clockwork, the pound fell against the US dollar into midweek. As mentioned, the fall was incited by unequivocally bad business sentiment surveys for August painting a very gloomy picture of the British economy. A PMI above 50 usually suggests expansion ahead, while anything below that points to contraction. So it was somewhat alarming that the composite PMI fell to 47.9, its lowest level in 31 months. Manufacturing recorded a dour 42.5, below both the projected level and last month’s figure. Meanwhile, the all-important services sector – which represents around 75% of the UK economy – fell to a downbeat 48.7, against expansionary expectations of 51. This weakness has thankfully gone hand-in-hand with reduced inflation expectations, causing markets to reassess the likelihood of further Bank of England (BoE) rate rises. But as we wrote last week, this puts downward pressure on sterling, since an aggressive BoE seemed to be the key factor supporting the currency.
Meanwhile, European PMIs were their worst in nearly three years, amid a sharp deterioration in consumer confidence. The preliminary Eurozone composite PMI for August fell to 47, below expectations of 48.5 and the lowest figure since November 2020. Manufacturing actually surprised to the upside, though the reported 43.7 was still very firmly in contractionary territory. Services were expected to post a practically neutral 50.5, but instead delivered the first contraction in eight months, with a reading of 48.3. This puts the European Central Bank (ECB) in an unenviable position. Just like the Bank of England (BoE), a deteriorating growth outlook has decreased expectations of an interest rate hike at the September meeting (which markets now price as roughly 50/50). But again like the BoE, labour shortages – particularly in Europe’s peripheral nations – mean the economy is vulnerable to persistent inflationary pressures from the wage-price spiral effect. If input prices were to increase again, as we have seen some signs of already, inflation could easily increase once more.
Is Japan’s central bank ‘ice age’ thawing at last?
The yield on 10-year Japanese Government Bonds (JGBs) rose to their highest level in nine years last week, at 0.68%. UK and US investors would be forgiven for being underwhelmed by this, as 10-year US Treasury yields, peaked above 4.3% at the start of last week, while UK 10-year gilts reached higher than 4.7% last week.
Historically, low growth, inflation and interest rates have kept JGB yield volatility almost non-existent for years. Stability was officially enshrined in 2016, when the BoJ began its policy of ‘Yield Curve Control’ (YCC), restraining the yield on the benchmark 10-year JGB to a ‘target’ rate around 0% and from rising above a specific yield level – previously 0.5%. But at the end of July, BoJ Governor Kazuo Ueda announced the 0.5% margin around the official zero target would stop being treated as “rigid limits”, and now merely be “references” for bank operations. Many analysts suggest this is effectively the end of Japan’s YCC, but according to Ueda the policy remains in place, just with a little more leeway. The shift may have looked rather technical, but marked quite a change in the pace of monetary injection, effectively slowing the central bank’s liquidity push.
A few economists have warned inflation in Japan could become ‘sticky’ unless the BoJ tightens quickly. Headline inflation has been holding steady at or around the 3.3% mark for most of the year, in a marked change to decades of deflation. But price rises have been consistently above the BoJ’s stated 2% target and for the last two months actually higher than US inflation. That said, Japan still lacks the main inflation pressure that has worried western central bankers for so long: rising wages. Japanese core inflation – excluding volatile elements like food and energy – was lower in July than the month before, with many analysts suggesting the country’s inflation impetus had already peaked. Indeed, in stark contrast to the US and UK, the BoJ has been actively trying to encourage wage rises to spur its economy.
It is therefore far too early for the BoJ to think about tightening policy in earnest, despite fears about abandoning YCC. It knows full well that a weaker currency and lower financing rates are improving Japan’s attractiveness both as an exporter and an investment destination. Policymakers also know inflation could quickly give way to deflation if global financial conditions change. A tweak to YCC is far from the end of Japan’s accommodative policy. This is good news for western investors, as JGBs so often act as an anchor in global bond markets. Higher Japanese yields are an important sign for the global economy, and thankfully one that is unlikely to destabilise markets.