Financial Update from Brewin Dolphin - 7 July 2023
The Weekly Round-up
Friday 7 July 2023
In her latest weekly round-up, Janet Mui, Head of Market Analysis, discusses the outlook for UK interest rates, housing market data, and weakness in the Chinese yuan.
Stocks have been losing ground in July after a strong first half of the year. Central banks remain hawkish, and investors have reckoned that a pivot to easier monetary policy isn’t on the table any time soon. This week saw bond yields moving up sharply across developed economies. The US ten-year treasury yield has once again surpassed 4%, after a slew of data pointed to a still-tight labour market. UK two-year gilt yields are getting close to 5.5% and have surpassed the levels seen during the mini-budget. The relentless rise in bond yields reflects the anxiety that interest rates need to rise further because inflation remains painfully sticky.
UK interest rate expectations
The expectation of higher interest rates is most acute in the UK, where headline and core inflation readings are elevated in absolute terms and relative to peers. There was a further increase in the market pricing of peak UK interest rates this week after a major broker warned that rates could go as high as 7% according to some metrics. The headline certainly is sensational and the media loves it. Looking at the details, the broker has a central and base case of UK interest rates at 5.75%. Currently, the market pricing is 6.5%, well above the ‘pain threshold’ that is widely believed to be 6%. We think that markets have gone too far in pricing such steep interest rate increases from here, though the risk is tilted to more hikes rather than fewer.
For the economy, particularly the services sector, the impact of higher interest rates has not been that detrimental yet. The resilience in consumer spending and business confidence got economists scratching their heads. The arguments as to why things have been better than thought include strong wage growth, cost-of-living support, household savings, and higher interest rates which benefit savers and are yet to feed through to many mortgage holders on fixed-rate deals.
Housing market data
That said, the impact of higher interest rates will eventually feed through to the housing market. We already saw weakness in housing market data, including mortgage approvals, sentiment surveys and asking prices. This week, Halifax reported that UK house prices fell 2.6% year-on-year, which is the greatest fall in over a decade. Halifax warned that more weakness will come as the squeeze on affordability from significantly higher mortgage rates will inevitably act as a brake on demand. Although the fall in house prices seemed muted, especially compared to the gains over the pandemic, the fall in transactions is very sharp. The number of properties changing hands in April and May was down by around a quarter from the same period in 2022. With mortgage rates surging in June, things could get a lot worse in the second half of 2023.
Interestingly, the US recently saw some pickup in housing market data. This is not good news for the Federal Reserve because US housing is a very interest-rate sensitive sector. If the sector starts to recover, inflationary pressures may be harder to tame. Indeed, a range of US data this week suggests the labour market remains too tight for underlying prices to return to the Fed’s 2% target. Ahead of the official US jobs report, the ADP employment survey (a private payroll processor) reported that nearly half a million jobs were created in June. Job openings remained high at 9.8 million – way above the six million people who were unemployed in June. The Institute for Supply Management’s (ISM) services index showed employment rising faster in June as well.
US labour market remains tight
On Friday, we saw the first miss in US jobs data in more than a year. Overall, it doesn’t change the narrative but, on balance, it is a slightly negative report from a market perspective. US hiring above 200,000 is still strong, but the number is a lot lower than expected and the previous two months’ job gains were revised down by 110,000. This means the job market is still tight, but not as hot as thought. The unemployment rate slowed to 3.6% from 3.7% as expected. It’s important to bear in mind that the unemployment rate is a lagging indicator. If interest rates remain higher for longer and recession risks build, the unemployment rate will likely rise. Perhaps the figure that worries the Federal Reserve the most is the pickup in wage growth to 4.4%, which was higher than expected. This reinforces the notion that inflation is going to remain sticky. Meanwhile, labour force participation remained stagnant for the past four months, meaning the increase of labour supply is not coming through despite the lure of higher wages. This signals supply constraints and that there is just not enough capacity for the economy to keep growing.
We knew from the latest Federal Reserve meeting minutes that Fed officials still foresee further rate increases and that the pause in hiking rates in June was not a unanimous decision. It is fair to expect at least another rate increase from the current 5.25%.
A 25-basis point rate hike has been fully priced in for July and the strong wage growth number just sealed the deal.
Chinese currency weakens
Meanwhile in China, markets remain focused on the disappointing post-pandemic economic rebound and the extent of weakness in the Chinese yuan. The Chinese currency has weakened past 7.25 to the dollar due to the increasing interest rate differential between the US and China. The Chinese authorities attempted to intervene in the currency market and continued to jawbone that they have many tools to support the currency. The thing is, a weaker currency is China’s friend as the global economy slows and exporting is getting tougher.
It is always difficult to understand China and to read the policy tea leaves. Why? Because actions from policymakers can be so contradictory. This week, for instance, president Xi Jinping urged countries to support global supply chains, but at the same time has imposed export restrictions on two key metals which are important for making semiconductors and electric vehicles. The Chinese authorities expressed a willingness to support the economy, but stopped buying bonds issued by local government financing vehicles (LGFVs) traded in the Shanghai Free Trade Zone. This is likely to put further strain on local governments who want to seek funding for their infrastructure and business projects. These developments suggest China will continue to pursue a tit-for-tat policy on US-China relations and trade policy. It also shows that generous stimulus is unlikely to come by as the Chinese authorities remain wary about the country’s debt pile.
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