It’s been a very busy week in financial markets
With three major central banks increasing interest rates, a raft of economic data and the International Monetary Fund (IMF) updating their global growth outlook – including an upgrade to their expectations for the first time in over a year. Financial markets have had a very positive week, both in equities and bonds, as investors reassess the path for interest rates amidst easing inflationary pressures.
The IMF published their latest global growth outlook, raising their expectations for the world economy after cutting their 2023 outlook three times last year. While the risk of recession remains, the IMF see a “turning point” in the world economy, thanks to resilient consumer spending and the reopening of the Chinese economy. They see growth bottoming and inflation declining in 2023, with growth of 2.9%, up from the 2.7% forecast in October. This remains below the long-term trend of 3.8%. Chief Economist Pierre-Olivier Gourinchas said, “the outlook has not worsened this time around, which in itself is good news”. Gourinchas warned however, that the light at the end of the tunnel is still distant, with the fight against inflation not yet won, meaning that monetary policy will need to remain tight, and some countries will need to tighten policy further. They note that risks to the outlook remain tilted to the downside, even though they have moderated. The IMF cite the key risks being a stalling in the Chinese recovery from Covid, inflation remaining stubbornly high, requiring interest rates to be higher for longer, an escalation of the war in Ukraine destabilising food or energy markets, and a broader tightening in financial conditions.
On the positive side, the strength of household balance sheets and tight labour markets should help to sustain consumer demand and easing supply chain bottlenecks and wage pressures could allow for less monetary tightening, allowing for a softer economic landing. The IMF singled out the UK as the only major developed or emerging market expected to shrink over 2023, with negative growth of -0.6%, but did note that the economy was “on the right track” following the Autumn statement that undid the short-lived policies of Liz Truss. Elsewhere, they expect the US to grow by 1.4%, the eurozone by 0.7% while the engines of global growth will be China and India, expected to grow by 5.2% and 6.1% respectively.
There has been a significant amount of economic data this week, with the highlight arguably yet to come in the monthly US employment report this afternoon. The usual start of month PMI data once again showed the weakness in the eurozone to be stabilising, while the US data took a turn for the worse. The US ISM PMI manufacturing data for January fell to 47.4, worse than expected and weaker than December. Bear in mind this is a diffusion index – a reading above 50 suggests economic expansion and anything under 50 points to contraction. The ‘new-orders’ subcomponent fell to 42.5 – you have to go back to 1952 for the last time this figure was so low without the US being in recession or falling into recession in the subsequent 12 months. For the eurozone, the manufacturing PMI data was broadly unchanged, at 48.8 – still in ‘contraction’ but the fact this has not weakened further points to the boost the eurozone has seen from the easing in energy prices in recent months. The four biggest eurozone economies – Germany, France, Italy and Spain, all saw their PMI numbers increase, with France and Italy moving back into ‘expansion’ territory.
For the UK, the PMI climbed slightly to 47.0. We will get the full picture today when the services data is published but for all the recent optimism in financial markets, the economic backdrop remains weak, and this is before the lagged impact of rate hikes really kicks in. We’ve also seen inflation data published for the eurozone, showing prices in January climbing at 8.5%, easing from 9.2% in December and lower than expected. Core CPI remained at a record high of 5.2% highlighting that while food and energy prices are easing, inflation elsewhere remains sticky. The fourth quarter GDP data for the eurozone surprised to the upside, with growth of 0.1%, meaning for now at least the eurozone avoids a recession, even as Germany, Italy, Sweden and Austria all saw contractions during the quarter.
There was encouraging news from China, with the Chinese Centre for Disease Control and Prevention reported the current Covid-19 wave is “coming to an end”. They reported no obvious rebound in cases as a result of mass travel for the Lunar New Year holiday. As a result of the end of the zero-Covid policy, the number of people travelling climbed significantly, with levels at 85% of those back in 2019. The University of Peking reported that as of 11 January, 900 million people had been infected. The conflict in Ukraine remains in something of a stalemate but Ukrainian Defence Minister Oleksii Reznikov warned of a major Russian offensive, saying Moscow could “try something” to mark the 24th February anniversary of the invasion last year. Reznikov told the BBC that Russia has around 500,000 troops available for the potential offensive – a much larger number than the initial invasion force last year.
It has been a very busy week of central bank meetings, with interest rates being increased in the US, UK and eurozone. As expected, the Bank of England raised rates by 50bps to 4%, the tenth increase in a row to counter inflation which, at 10.5%, remains close to a 40-year high. The Bank revised their economic outlook, having previously said the UK economy was expected to be in recession from the end of 2022 until mid-2024. The more optimistic outlook now expects a shorter period of contraction starting this quarter and lasting until the end of the first quarter in 2024. The main reason for the Bank to anticipate a contraction of just 1% compared to the 3% previously forecast is because “wholesale energy prices have fallen significantly”. The Bank expected inflation to ease to 8% by June, and to ease further to 3% by the end of this year. Bank Governor Andrew Bailey said “we have done a lot on rates already, the full effect of that is still to come through. It is too soon to declare victory just yet… inflationary pressures are still there”.
The European Central Bank also increased rates by 50bps as expected and reiterated they will “stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to its 2% medium term target”. The ECB made clear that investors should expect a further 50bps hike in March “in view of the underlying inflation pressures”. The market interpretation of the meeting was dovish, focussing on the ECB’s statement suggesting that after March, they would “then evaluate the subsequent path of monetary policy”. Investors are assuming that a further easing of inflation thanks to lower energy prices means the ECB will not need to raise rates as much as previously expected. ECB President Christine Lagarde helped the market mood, saying inflation pressures were “more balanced” and that “the recent fall in energy prices, if it persists, may slow inflation more rapidly than expected”. The US Federal Reserve (Fed) eased their pace of rate hikes to 25bps, but warned of more to come, noting that while inflation pressures had “eased somewhat”, inflation remained “elevated”. The Fed statement said that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time”.
Equity markets got very excited around Fed Chair Jay Powell saying, “for the first time the disinflationary process has started” but his tone was hawkish in his other comments, including saying “the job is not fully done, so I think it would be premature, very premature, to declare victory”. Powell said that there had been some “encouraging signs” that price pressures were easing, the Fed “will need substantially more evidence to be more confident that inflation is on a sustained downward path”. It’s clear the Fed is closing in on a halt to rate hikes, but Powell made clear that they remain more concerned about the risks of doing too little rather than too much. The gap remains between the Fed suggesting rates will peak and then stay on hold, and financial markets that continue to assume that rate cuts will follow shortly after the peak. The economic data in the second half of the year will likely determine how quickly the Fed reverses this round of monetary tightening; in the meantime, equity markets will continue to hold on to any perceived dovish comments coming from Powell in the hope it means monetary easing is imminent.
