Financial Update from Brewin Dolphin - 18 November 2022
The Weekly Round-up
Friday 18 November 2022
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the US midterm election results, the UK chancellor’s autumn statement, and interest rate projections.
The pain trade
The momentum in stocks has been fading a little this week. Investors are generally positioned cautiously in both stocks and bonds, wary of the economic weakness still to come and further rises in interest rates. But just because investors don’t believe the worst of the bear market is yet behind us, it doesn’t mean there can’t be powerful countertrend rallies as we have seen this month. The so-called pain trade is a turn in the market which seems to frustrate the maximum number of investors possible. That pain trade was magnified in terms of economic regions with Europe and China both rebounding strongly.
A modest boost to China sentiment came amid meetings between president Xi Jinping and the other leaders, the most notable of which was the US. Whilst nothing particularly concrete emerged, other than a consensus that the use of nuclear weapons should be universally opposed, any dialogue between strategic rivals is to be encouraged.
Chinese growth data disappointed this week as the economic slowdown continues. There have been measures to ease Covid restrictions and support the property sectors, but these support measures are tweaks rather than reversals of the policies that have weighed on activity this year.
The cycle turns
The market is particularly capable of dramatic swings during times when liquidity is low, such as the weeks around the festive period. This year it will be compounded by quantitative tightening as well.
However, it’s hard to argue with the view that strong labour markets will maintain inflationary pressures. These pressures can only be dispersed by a contraction of employment, during which a recession would be hard to avoid. Until that happens, monetary and fiscal policy will be quite restrictive.
This year may have been the year of monetary consolidation as interest rates have risen and asset purchases are being unwound. But as we approach 2023, fiscal policy will take a greater role too.
The House flips
This week saw the final confirmation that the Republicans will take control of the House of Representatives whilst the Democrats will retain control of the Senate. The relevance of this is that it sets the stage for a period of policy stability in which it is difficult to advance legislation for multiple reasons. Most obviously, the two houses may clash, and the president may veto legislation coming from them. But even within each house, it will be difficult for either side to keep their own caucuses pointing in the same direction.
While policy remains stable, execution can be inhibited by a split congress. The House will be reluctant to authorise funding for a government that was generous during its first two years, so we can expect two years of wrangling over debt and shutdowns as we move into the second half of president Joe Biden’s first term.
The budget tightens
Maintaining party unity can be difficult within two-party political systems as disparate ideologies coalesce on either side. There was no hiding the fact that the new UK Conservative government is a very different animal from its predecessor. Kwasi Kwarteng’s economic agenda wasunceremoniously dumped at this week’s autumn statement, with the new chancellor, Jeremy Hunt, boasting that the government has reversed “nearly all the measures in the Growth Plan 2022.” Hunt had openly promised that everyone would be paying more tax and he achieved this by cutting the threshold at which the highest rate of tax is paid and employing fiscal drag. This is a stealth tax that occurs when allowances aren’t uplifted in real terms, meaning that inflation causes the tax burden to increase. With so many allowances remaining frozen for so long, and in the face of such high inflation, the burden will be felt across the income spectrum but tilted towards the wealthy (which reduces the economic impact). Fiscal drag is sometimes described as a silent thief, but this was more smash and grab than artful pickpocketing.
Fiscal policy will support the UK government in offsetting the impact of higher energy prices through a combination of price caps and subsidies. Even with the price caps, UK inflation rose this week to what will hopefully be its peak. Although energy bills will rise again in April and will remain historically outsized as a share of disposable income, the increases will be smaller than we have been used to, so their impact on inflation will decline.
The market’s reaction was certainly less severe, but borrowing costs rose as Hunt unveiled his cuts. As ever, this reflected the bad news having already been leaked. The greatest tightening since George Osborne’s 2010 budget lacked the finesse of measures like pension reforms, which pulled forward revenue and savings under the guise of liberalisation.
Are rates cresting?
UK interest rates are now expected to peak around the summer of 2023 at just over 4.5% compared to 3% right now. Despite the reaction to the autumn statement, the new government has been very effective in pulling down that future interest rate trajectory, which will follow through into lower borrowing costs for mortgage holders.
In the US, rates are expected to rise a little further, but the Federal Reserve has been working hard to cement the idea that rates will not fall thereafter. James Bullard of the St Louis Federal Reserve stressed that this was the lowest level he could see rates getting to.
For the current quarter, US economic activity momentum remains reasonable. Accelerating retail sales and continued strong employment mean that personal consumption remains a powerful driver for growth, more than offsetting the main source of drag on growth which comes from housebuilding.
Bonds have rallied as investor expectations of a slowdown in the economy have gathered pace, and while a recession has probably started in the UK, the US retains some economic momentum. UK government bonds no longer offer the dramatic value they did two months ago and have begun to reflect the likelihood that, over time, interest rates will have to start falling again.
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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