Are We There Yet?
As state schools break up for the summer and families embark upon their summer holidays, the above question may be asked more than a few times. For those travelling by road, rail or plane, there will be challenges from high fuel costs to strike action and delays. The other question that might be asked is ‘have we left yet!?’
For investors, the title question is about whether we have reached:
- Peak inflation
- Peak pessimism
Financial markets have been volatile in the first half of July. Economic data has underlined the difficulties facing central banks and their governments. Labour markets remain tight as evidenced by the US employment report in the first week of the month. In the past week, US inflation again exceeded forecasts at 9.1%, the highest in forty years. Big contributors to the inflation figure in the US have been energy and food with the former rising 42% in June 2022 compared to June 2021. There should be some relief from a weakening of fuel prices next month. Ex food and energy, the inflation data shows signs of moderating. The following graph from the US Department of Labor illustrates that point.
Supply chain pressures are easing as the following chart from the New York Federal Reserve illustrates:
As is the cost of global freight:
Better than it has been (see the following chart) but still bordering on the extreme. Such readings have been a useful contrary indicator. It’s not saying the worst is over but a lot of fear is already priced in.
A Key Question – What’s Priced In?
Quite a lot, but with investors’ fear levels where they are (see previous chart), markets are understandably twitchy. As the right-hand graph of the next charts illustrates, stocks are no longer expensive, do they need to be cheaper to attract fresh buying? Earnings forecasts from analysts need tapering but, as we know from previous market moves, stocks can turn before earnings forecasts are adjusted.
Institutional cash levels are elevated as the following chart from the Bank of America Global Fund Manager Survey illustrates.
JP Morgan CEO, Jamie Dimon, talked up the US economy, exampling the health of the US consumer and its ability to counter recession. Dimon’s comment was probably based on data from the US National Retail Federation’s data as the following charts show:
Whether that comment was meant to distract from disappointing second quarter earnings from the US’s largest bank is a moot point. The recession argument could be somewhat academic as forthcoming data may evidence the US economy is already in recession after the first quarter’s GDP (Gross Domestic Product) decline of 1.6% (annualised). The much-watched Atlanta Federal Reserve Now Real GDP forecast for the second quarter is indicating a negative outcome for the second quarter of 1.5% as the following chart shows.
UK GDP for May 2022, surprised by being a positive 0.5%. For the three months to end May 2022, the UK economy grew 0.4%, led by services
In China, second quarter growth disappointed at 0.4% on an annualised basis. Clearly the Covid-induced lockdowns have been a key factor in the lack of economic activity. This renders the official forecast for Chinese GDP of 5.5% for 2022, unlikely even as lockdowns ease in the second half of this year.
Inflation – a short term problem that gives Central Banks the chance to act?
Recession is more palatable for central banks than persistent inflation. A higher US consumer price inflation print gives the Federal Reserve the excuse to take risks with engineering a recession to avoid the more unpleasant spectre of high inflation. As we have said previously, raise rates while you can before it becomes economically and socially unpalatable. High energy and food prices are a tax on consumers’ disposable incomes so the real conundrum for central banks is how they are going to do something about high inflation to ward off higher wages in tight labour markets. Ideally, they need unemployment to be rising – which it isn’t yet but should in an economic slowdown/recession. Expectations are for a 0.75% rise at the next US Federal Reserve meeting on July 26-27. A one per cent increase is a possibility.
This week should see the first interest rate hike in eleven years from the European Central Bank (ECB). A 0.25% rise is expected which still leave official rates in negative territory. A 0.50% rise would take official rates to zero.
The Bank of England is expected to raise the bank rate by 0.25% or 0.50% on August 4th at its next meeting, from the current 1.25%.
With the US central bank leading the way in magnitude of interest rate increases, the US currency has been firm which will help keep a lid on US import prices. The relative strength of the US economy versus its European counterparts has helped too. Political pressures in Europe and the UK haven’t helped their currency performance although the US mid-term elections aren’t far off in November this year.
Longer-term, inflation is not deemed to be an issue given where breakeven rates are relative to past and most recent history. Having touched 3% earlier this year, the rate is now down to 2.36% at the last reading as the chart below from the Federal Reserve Bank of St Louis shows.
While risk assets such as equities may be forming a trough after a torrid first half of 2022, we have maintained relatively high cash weightings. In multi-asset funds, we have not been seduced by the rally in government bond markets’ lower yields reflecting US and European central banks’ preference for a recession. However, the slower growth outlook has led us to trim our industrial commodity exposure in favour of topping up our Asian consumer focused theme given the almost polar opposite monetary policy agendas in the region led by China. As we have noted before, the staple food of Asia is rice which does not have any supply issues and will not translate into higher food inflation in the region.
We thank you for your continued support and if you have any questions in these difficult times, please do not hesitate to contact any of the TBAM team.