Financial Update from Brewin Dolphin - 2 December 2022
The Weekly Round-up
Friday 2 December 2022
In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses stronger-than-expected US jobs data, the housing market downturn, and hopes of a China reopening.
Global markets enjoyed a flush of positivity this week, spurred by China’s softening stance on Covid and Federal Reserve chair Jay Powell’s acknowledgement of smaller interest rate increases ahead. That was until the November US jobs report suggested the fight against inflation is far from over.
The most eye-popping data was average hourly earnings, which rose by 5.1% year-on-year, up from 4.7% year-on-year the previous month and well above consensus estimates of 4.6%. Wages increased by 0.6% on a monthly basis, the fastest pace of growth since January. Labour participation continued to fall, meaning the supply of labour is not rising to help cool that strong wage growth. Job creation was robust, with employment climbing by 263,000 in November, while the unemployment rate stayed at 3.7%. This suggests the labour market is not cooling as much as hoped and that means core inflation may stay higher for longer. All else being equal, the jobs data is bearish for equities and bonds. While it is important not to get too sensitive over one month’s worth of data, the slowing trend in labour participation is worrying from a structural perspective.
Interest rate trajectory
So what does it all mean for Federal Reserve policy? Taking what Powell said this week at face value, the Fed will raise interest rates by 50 basis points this month, a retreat from the previous four consecutive 75 basis point rate hikes. This provides further confirmation to markets that upcoming rate rises will be moderated in terms of size and pace. Importantly, he said that goods inflation has decelerated and that shelter inflation, by far the biggest component of headline US inflation, was also slowing. Powell also reiterated that the terminal Fed funds rate (the level at which it is expected to stop raising rates) may need to be higher than previously forecast, that it will be necessary to hold monetary policy at a restrictive level, and that services costs remain a challenge, particularly given evidence of scarce labour supply.
Although the labour market is arguably the most important thing to look at, there is plenty of US economic data to digest for analysis. The latest data suggest US inflation pressure is moderating, consumers are resilient but cautious, and the US housing market is grinding to a halt. This suggests it is appropriate for the Federal Reserve to pause soon and observe the lagged impact of higher rates. That is why despite the jobs report, traders’ expectations for the peak in the US Fed funds rate are pretty much unchanged and stable at just below 5%. What the market finds it difficult to price is probably less about the peak US interest rate, but more about whether there will be rate cuts in the latter part of 2023. Currently, the market expects about two 25 basis point rate cuts in Q4 2023 and that carries the risk of being too optimistic.
Deceleration in activity and inflation
The key US economic data released this week included the personal consumption expenditures (PCE) price index excluding food and energy, which is an important inflation measure for the Federal Reserve. This rose at a lower-than-expected rate of 0.2% month-on-month in October, the second-smallest increase this year. The deceleration of PCE prices is significant as inflation is such an important driver of monetary policy. It adds to the case for a more gradual pace of rate hikes going forward.
Personal spending adjusted for inflation rose 0.5% in October. This was the biggest increase since the start of 2022 and points to resilient consumer strength. It is a continuation of the resilient consumer spending seen in the second estimate of US third quarter gross domestic product (GDP). However, by resilient we don’t mean robust. It is undeniable that high inflation and economic uncertainty contributed to a slower trend in consumer spending and a fall in consumer confidence.
From the US GDP release, we saw that after-tax profits as a share of gross value added (GVA) for non-financial corporations, a measure of aggregate profit margins, shrank in the third quarter to 14.9% from 16.2% in the second quarter. This indicates greater pressure on corporate margins as wages and input costs rise. Businesses may find it increasingly difficult to pass on higher costs to consumers as the economy slows. There is a risk of further corporate earnings downgrades in 2023, which is why we are not convinced that the current equity rally is the start of a sustained bull market.
Housing market downturn begins
Higher interest rates are having a more immediate impact on the global housing market, with countries including Sweden, Canada, Australia and New Zealand seeing a downturn in house prices. In the US, the S&P CoreLogic 20-City home prices saw the third consecutive month of contraction. Pending home sales, a leading indicator of future sales, plunged 4.6% MoM and 36.7% YoY. Consumer surveys suggest US households now see home buying conditions as being at their worst levels in at least a generation.
Here in the UK, we face a similar problem with rising mortgage costs and affordability challenges. This week, Nationwide’s house price index showed prices fell by more than expected in November, down 1.4% MoM. This marked the third consecutive monthly fall and the fastest drop since June 2020. Year-on-year house price growth slowed to 4.4% in November from 7.2% in October.
Housing affordability for potential buyers and home movers has become much more difficult at a time when household finances are already stretched from the cost-of-living crisis. This week’s UK credit data showed mortgage approvals slowed by more than expected in October, down 10.6% from the previous month and almost 20% in the past two months alone. The drop is likely affected by lenders withdrawing mortgage products due to rate volatility induced by the mini-budget. While many of these products have returned and five-year fixed rates have dropped below 6%, the rates on offer remain very elevated. As mortgage approvals are a reliable guide to housing activity in the future, it is probably prudent to expect more muted UK housing transactions and prices slowing more in the coming quarters.
The China Covid pivot
Equities in China and Asia, as well as commodities, have been supported this week by hopes of China reopening. Indeed, there are more signs that the Chinese government is softening its Covid-zero stance after widespread protests. While the central government did not directly respond to questions on protests, it tried to blame local governments for their ‘one-size-fits-all’ restrictions in handling Covid outbreaks. The government said it will accelerate vaccine boosters for the elderly, something which has been a big impediment to a successful reopening. Overall, there are signs that officials hope to downplay the risk of Covid, a big change from the previous stance. According to Bloomberg, stories of people who survived infections are popping up in state-run media, Beijing indicated some Covid patients could isolate at home, and the party mouthpiece People’s Daily urged citizens to take responsibility for their own health.
We think the tone from the authorities has turned conciliatory and the overall direction remains a constructive one, where the worst of Covid-zero restrictions in China are behind us. It is likely to be a ‘two steps forward, one step back’ process however, given the delicate balance of reopening while limiting an increase in infections in a vast country with little herd immunity.
Financial markets will remain very sensitive to Covid developments in China. There is a general sense of FOMO (fear of missing out) in case of a big rally in Chinese stocks, which could support the current momentum in Chinese assets. Meanwhile, the People’s Bank of China continued to pledge support to the economy by cutting the reserve requirement ratio last Friday, the second time this year. The improvement in credit availability and liquidity will be helpful at a time when the economy is trying to get back onto a stronger footing.
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