Financial Update from Brewin Dolphin - 16 December 2022
The Weekly Round-up
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the latest US and UK inflation data, interest rate hikes and the risk of a US recession.
The good news
The market’s biggest concern this year has been inflation, which rose to multi-decade highs in most regions around the world. After a few false dawns, it does seem likely that inflation has peaked. Price growth had been expected to slow again during November, and the very high rates reported at the end of 2021 create scope for inflation to fall quite fast due to base effects.
Reported US inflation for November was, in fact, even lower than had been expected. Some of the key costs that have been squeezing consumers eased during November. Gasoline, which had reached $5 per gallon in June, has fallen to $3.20 per gallon in recent weeks. Food prices have been falling and underlying agricultural prices suggest that they will continue to do so. These prices tend to be volatile and are influenced by commodity markets, not always reflecting domestic demand. Focus often therefore lands upon core inflation, which carves these elements out. Core US inflation was very low as well – most notably goods prices, which saw outright declines, and services, which grew at a slower pace. There seems little evidence of the much-feared wage-price spiral or unanchored inflation expectations, with the evidence from prices themselves backing up surveys that show consumers expect inflation to return to normal over the medium term.
While this is true of the US, the UK picture was more nuanced. November’s UK inflation data was softer than expected, which is most welcome, but a critical difference is that the monthly rise in US core inflation, if it persisted, would be enough to see inflation return to normal levels. In the UK, considerably more improvement is needed. It is also less likely because we do know that some additional increases in utilities bills are likely from April when the fuel cap rises further. The falling oil price has had less impact in the UK because the pound has been weak (until recently) and the high level of taxation on motor fuel in the UK mutes the impact of commodity price changes (in this case, falls). Inflationary pressure has reduced in most markets but is expected to persist longer in the UK than in the US.
Part of the softness in consumer prices relates to falling costs of things consumers must buy (like food and energy). This is good news for growth, which doesn’t benefit from rising spending on higher commodities. But some prices were weak, reflecting the tightening measures taken by the Federal Reserve. A big source of inflation in the US this year has been car and truck prices. These have moderated as interest rates have risen. Most vehicles are bought with loans, which have made such purchases less affordable as interest rates have risen.
November’s retail sales showed that consumers were buying fewer vehicles even as the prices of them fell. Similar trends were in place for building materials, which are often bought as part of loan-financed projects.
Investors have been growing increasingly concerned about a recession during 2023. The key proxy of recession risk is the yield curve, as expressed by the difference between a two and ten-year government bond. The current yield curve suggests that the risk of a recession is at its highest since the early 80s. That’s also reflected in the Philadelphia Fed’s survey of professional forecasters, by which measure a recession next year would be the most anticipated recession in history. Both of these phenomena are reflected in the market’s expectation that interest rates will not just peak within the next few months but actually start to fall. This has been a driver of the recent rebound in markets. The prospect of a bright new era of monetary easing is enough to get markets rallying.
Interest rates may be close to their peak, but they are not there yet. This week saw the unusual coincidence of the three most closely watched central bank policy meetings (UK, US and eurozone). All three raised interest rates by 0.5 percentage points. The Bank of England exposed the policymakers’ dilemma through a three-way split on the committee, with two members wanting to leave rates unchanged and another wanting to hike by another record 0.75%. The European Central Bank (ECB) and Federal Reserve were united in their hawkish tone.
Fed chairman Jay Powell continues to stress that he does not anticipate a recession and sees no reason for rates to fall as the market currently anticipates. There are some good reasons to share his optimism. Recession risks should be declining as inflation has slowed to less than wage increases in recent months. US consumers, therefore, are accumulating jobs at a historically fast pace, and earning salaries which are finally rising again in real terms.
The main drag on the economy is the housing sector, where activity has ground to a halt in the face of higher mortgage rates, high building costs and squeezed prospective buyers’ incomes. House prices are falling too, which together with the falls in stock and bond markets will make consumers less keen to spend. Overall, though, with markets recovering a little and wages rising in real terms, these threats are receding and the prospective recession is becoming less severe and more distant.
How confident is Powell that recession will be avoided? The main inconsistency in his expectations is that the latest summary of economic projections included an expectation that the economy would expand by 0.5% next year, which is low but inconsistent with a recession. The Fed also expects unemployment to rise by 0.9 percentage points. Historically a rise of 0.5% would be consistent with the onset of a recession.
And while the latest data showed inflation coming down, the Federal Reserve increased its forecasts for both inflation and interest rates during 2023. The Fed will be cautious at declaring victory over inflation even if it is bold in declaring a recession will be avoided.
A confused message
The ECB’s inflationary projections also sounded hawkish. The ECB expects inflation to remain above target into 2025. This reinforced the message that interest rates would need to rise significantly. During the Q&A session, ECB president Christine Lagarde’s answers indicated that further hikes of 0.5% each time are likely and that the market’s current expectation of a 3% terminal rate of interest is too low. This was enough to prompt a sell off in European bonds and a rise in the euro.
So the economic environment remains challenging, particularly in the UK where inflation seems more persistent, partly reflecting higher energy prices, but which will be countered by rising mortgage costs and (from April) higher taxes. The labour market remains robust though and one of the positive developments was the rise in economic potential, which came as a large number of workers seem to be making themselves available for work once more. Most of these had previously been classified as long-term sick.
Elsewhere, rising equity and bond markets, falling mortgage rates and lower non-discretionary costs (like oil) serve to reduce the pressure on consumers, reducing that recessionary risk.
The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.
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