Financial update from Brewin Dolphin - 6 January 2023
The Weekly Round-up
Friday 6 January 2023
In his first weekly round-up of 2023, Guy Foster, our Chief Strategist, looks at how this year could compare with 2022, and analyses the latest set of US labour market data
The first week of 2023 is over. How will this year compare with last year?
The widely held anticipation is that inflation will now fall and could do so quite quickly through a combination of fundamentals and technical factors. From a technical perspective, the fact that rates of inflation have been so high makes it harder for them to continue at the same pace. Similarly, the very high month-on-month rates of inflation suffered over the last 12 months will gradually drop out of the annual inflation rate. But from a more fundamental perspective, energy and many food prices, which tend to be the most volatile consumer prices, were weakening towards the end of 2022. Durable goods prices, which typically tend to be very stable, were very strong during 2022 in a way which is unlikely to be repeated. So inflation is likely to continue to fall over the coming months. That has led investors to expect interest rates to increase more slowly, pause and eventually fall.
This week’s data supported that theme with early provisional inflation figures from Germany and France both showing falling inflation. In Germany’s case, this was a distortion caused by energy price support from the government. For France, it came despite the withdrawal of support which will be phased over the coming months.
Low inflation and falling interest rates would be a great environment for investment. Usually, these are closely followed by recovering economic activity. The challenge, therefore, for this year is that at the moment the economy does not seem to be doing badly enough. Although surveys continue to show that confidence among businesses and consumers is very depressed, last year’s pessimism was driven by the challenges of dealing with inflation, rather than because demand for either labour or products was weak. Understandably, the expectation is that last year’s contraction in real incomes will lead to a recession in 2023, but it’s far from certain. As mentioned, survey data is depressed and would be consistent with an economy sliding into a recession. The most tangible of these data are the purchasing managers’ indices because they indicate that companies are seeing fewer new orders than in previous months. That would be consistent with a recession, but also aligns with a shorter-term three-year manufacturing cycle, which occurs frequently without proving recessionary.
Consumers have been able to dig into cash reserves to weather last year’s inflationary storm (particularly in the US). It has left the savings rate at what seems like an unsustainably low level. But recent months have seen real incomes rising because, in the very short term, inflation has slowed while wages continue to rise. So a big question is whether the trend for wages continues or whether it falters, as it would if the US were dropping into a recession.
We had lots of labour market data to try and answer that question, but the headlines, as ever, were made by the non-farm payroll report, which showed robust jobs growth again in December. The pace of jobs growth is historically healthy, although it has been declining steadily over the last year and continued to do so in December. But that doesn’t necessarily mean the labour market is easing.
Many consider the best test of labour market strength is the number of outstanding job openings, which continue to show an outright shortage of workers. Last year, they surged to unprecedented levels and, although they have subsequently declined, which fits with the general disinflationary narrative, the overall level of job openings remains very high. The most recent releases seem to have plateaued, arresting that decline. The same can be seen in the “quits rate”, which is an indication of people’s willingness to change jobs, often motivated by higher wages. The number of new claimants of unemployment benefits declined over the Christmas period. These remain close to their all-time lows.
So there seem to be jobs for anyone who wants them, resulting in the unemployment rate falling to 3.5%, which is the lowest it’s been in more than 50 years. All of this should make the Federal Reserve pretty nervous, but there are mitigating factors, including the fact that one year of high inflation is assumed by most consumers to be a one off. Inflationary expectations have not risen materially, which perhaps explains why wage inflation has begun to slow despite the worker shortage. This means the Fed’s worst fears of a self-reinforcing cycle of higher prices, causing higher inflation expectations, which in turn cause higher wage demands that can only be met by raising prices (the so-called wage-price spiral) does not seem to be taking hold.
This week we raised our recommended bond weighting after a useful back up in yields over the last few weeks. After last year, in which the correlation between bonds and equities was very positive, this year these assets should offer more diversifying properties. Bonds will particularly offer protection against recessionary scenarios which are likely approaching, even if the timing is very uncertain. We increased our recommended weightings in UK bonds (gilts) in recognition of the fact that the UK economy has more headwinds to face than other regions. Inflation will continue to frustrate UK consumers, albeit to a lesser extent than last year. In April, taxes and utility bills will rise.
Higher utility bills remain likely in the UK despite the falls that have taken place in European gas prices. Because the winter has proven surprisingly warm (a phenomenon we should have mixed feelings about) and Europe has been able to attract record liquified natural gas (LNG) imports, prices have fallen by about 50% since the beginning of December. They need to fall by a further 30% in order for the planned price increases in April, associated with the rising utility bill cap, to be avoided. Those increases will come at a time when taxes will rise for most employees too, putting greater pressure on consumers.
With the US economy still strong, we have stayed underweight overseas bonds for now. Another factor is the potential for further policy changes from the Bank of Japan (BoJ), which unexpectedly widened the acceptable range for ten-year government bond yields to 0.5% in the week before Christmas. The upper threshold is now 0.5% and the BoJ announced an unscheduled bond buying programme to ease the transition. It has not, however, been buying as many bonds as we might have expected, which would suggest it is keen to see where the yield might naturally lie, perhaps paving the way for a further relaxation of the bond buying policy. However, this has resulted in the yield closing above the official upper threshold. Presumably, therefore, the BoJ will enter the market on Monday to bring yields down.
Pressure to abandon yield curve targeting remains because participants continue to complain about liquidity. However, if the BoJ was to do so, it would seem to represent an admission that the policy has failed to achieve its target of returning Japan to enduring positive inflation. Data this week showed Japanese wage growth slowed in November, despite the surge in consumer price inflation. Policymakers and workers will be hoping the spring wage bargaining season sees some improvement.
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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