There’s been plenty to contemplate in markets over the past fortnight though for some, me included, the start of the Rugby World Cup has proved a very welcome distraction
With three rugby players in the Willis household, at the under 9s, 11s and 13s level, we have been watching as many games as possible. My daughter in the under 9’s has just stepped up from tag rugby to contact – hopefully she doesn’t have to play against Fiji any time soon!
The market mood remains relatively sanguine around the continuing unknowns on inflation, growth and rates. We have seen more numbers pointing to the US labour market slowing, and in the UK, further evidence of sustained wage pressures, which suggests another rate hike from the Bank of England next week looks highly likely.
Meanwhile, the European Central Bank met yesterday and chose to raise interest rates by 25 basis points to 4.5%. While the ECB’s forecast inflation is expected to slow down to 2.1% by 2025, they are clearly not comfortable with the current pace of decline in inflation, which in August was 5.3% year on year. The market reaction was relatively muted given that expectations of a hike had increased from a 24% probability at the start of last week to a 66% probability in the hours before the announcement.
Nonetheless, the euro weakened on downgraded growth forecasts of 0.7% for 2023, climbing to 1.5% by 2025. The hike comes despite signs that the weakness in the eurozone manufacturing sector has broadened into services, with the latest PMI numbers indicating the overall economy is in contraction. Earlier in the week the European Commission downgraded their growth forecast to 0.8% and upgraded their inflation forecast to 5.6% for 2023. The latest inflation forecasts from the ECB matches those from the commission for 2023, with inflation set to ease over subsequent years though ultimately, the ECB remain concerned that inflation will be too high for too long, and are comfortable keeping rates at a restrictive level for an extended period, “for as long as necessary” as their statement puts it.
But it does look like the ECB is done with rate hikes for now, with the statement adding that “based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target”. What we don’t yet know is how much economic pain they are willing to impose given the already fragile state of the eurozone economy, or whether this hike will in hindsight look unnecessary given the current weakness in growth and lagged effect of the nine hikes we have seen previously yet to fully feed through to the economy.
Moving on to the economic numbers, let’s start in the US with the latest employment report, which at the headline level beat expectations with 187,000 jobs created in August, against 170,000 expected. We also saw a negative revision of -110,000 to the July data. Total negative revisions over the past 7 months now total -355,000. The unemployment rate saw a meaningful increase to 3.8% from 3.5%, as more people re-entered the workforce. One notable leading indicator in the data was the decline in temporary staffing, which fell for the 7th consecutive month. This has historically been a strong leading recession indicator but it decreases in the months preceding a recession. The headline payroll numbers only tend to turn negative once the recession is underway.
The softening in the data is most notable in the job opening numbers, which have now seen significant declines in recent months. Again, this follows the usual pattern of companies cutting vacancies before cutting actual jobs. Despite an increase in the month-on-month rate of inflation to 0.6%, equities and bonds saw little reaction to the latest US CPI data. The increase in the pace of inflation was due to a sharp rise in gasoline prices, up 10.6% on the month. The year-on-year CPI rate climbed to 3.7%, with core CPI (which excludes food and energy prices) unchanged at 4.3%. The Federal Reserve’s 2% target is still some way off, but markets see only a 46% chance of another Fed rate hike this year.
The PMI data for manufacturing continued to be weak across western economies and was considerably weaker in the UK and eurozone than the US, though all were in “contraction” territory. The services data was a little more nuanced, with the US posting the strongest level since February and well ahead of expectations. However, the UK and eurozone services numbers fell into contraction territory suggesting that third quarter growth will be weak. For the eurozone this continues a theme of recent quarters, with growth for Q2 revised down last week to +0.1%. This follows growth of 0.1% in Q1 and a contraction of -0.1% in Q4 last year. So, the eurozone economy has been stagnating for some time. Talking of stagnation, the UK had a poor start to the third quarter, with GDP data for July, published on Wednesday, showing that the economy shrunk by 0.5%, worse than the 0.2% contraction expected, and contrasting with the growth of 0.5% seen in June. The slowdown was exacerbated by the poor weather weighing on retail sales and continued labour disputes.
Elsewhere in the economic numbers, we’ve seen the UK wage data unchanged at a record high level for the second consecutive month at 7.8% year on year in July. Alongside bonuses and various public sector pay dispute settlements, wages were up 8.5% year on year. UK wages are now running ahead of CPI, and while Andrew Bailey sees “policy near the top of the cycle” in comments made last week, there will be concern at the BoE over persistently high wage settlements even as CPI trends lower. However, other elements of the labour data were more consistent with a slowing employment market, with payrolls shrinking by 1,000 versus an increase of 30,000 expected, and the unemployment rate climbing to 4.3%. Markets are pricing an 80% probability the BoE will hike rates by 25 basis points – what would be a 15th consecutive hike – next week.
We’ve seen a few more “stagflation” headlines floating around recently not least because of the oil price continuing to creep higher. During the past fortnight the oil price has closed above $90/barrel for the first time this year, and at the time of writing on Friday morning, currently sits at $94.40/barrel. The reason for the higher oil price is not a positive one – this is not demand led thanks to a vibrant economy but thanks to tighter supply as Russia and Saudi Arabia have committed to extend production cuts to the end of 2023. Saudi’s daily output is well below potential levels – an elevated oil price helps to balance the budget, while Russia will be happy to see elevated oil prices, firstly to help their own finances, and secondly to push up gasoline prices in the US. Given the impact higher gasoline prices have on US sentiment, Russians will be more than happy to see President Biden’s popularity remain in the doldrums as the 2024 election looms on the horizon. The oil price is up 31% from the 2023 lows in June and 3% higher than 12 months ago.
The impact on energy prices has begun to feed into the inflation numbers – the recent trend down in inflation data is expected to pause in the coming months, as seen in the US CPI numbers this week. History shows that inflation tends to come in “waves” after the initial spike and it may well be the same this time. Central banks are only too aware of this, hence all the talk from the US, UK and eurozone of rates reaching a plateau. Huw Pill of the Bank of England described a “Table Mountain” path for interest rates ahead. Markets have moved out their expectations for rate cuts once the peak in rates is in, but expectations may yet need to move further into 2024 if inflation fails to gravitate closer to central bank targets.
The path of inflation will also be driven by the wider economic backdrop and the glade path for economies into a “soft” or “hard” landing. The lagged impact of interest hikes should have a more significant impact on economic activity in the coming months, though the impact has been clearly softened so far in this cycle by the fact that consumer and corporate balance sheets were in a very healthy state, boosted by excess Covid savings, going into this economic downturn, and also helped by the slower impact of rate hikes following borrowing rates being termed out for longer so that fewer households and corporates can refinance.
But that time will come – excess savings are now almost depleted and both households and companies will need to borrow again at much higher rates. The soft versus hard landing debate will come for some time yet, and a soft landing may well end up just a pathway to a hard landing further down the line. This debate is likely to continue to drive market sentiment for several months yet, but the potential downside risks to the economic outlook do not appear priced in at current market levels.
Have a good weekend,
Kind regards,
Anthony.
