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July 2022 Monthly Review

Inflation vs Recession

In a month where inflation numbers in the US, UK and Europe climbed higher again, most financial assets had their best month for around two years.  Here is Europe’s latest inflation release, note the rise in core inflation:

Source: Bloomberg

Consequently, the European Central Bank (ECB) raised its official rate by 0.5%, more than expected finally taking official rates back up to zero.  The Fed Funds rate was raised by 0.75% as was largely flagged by Fed officials.  The Bank of England is expected to raise base rates by 0.50% to 1.75% in the first week of August in response to this situation – rightly or wrongly:

Even commodities, which had a poor start to July, rallied strongly into the final days of the month.  The concept that US, UK and European central banks would press harder on the interest rate brake with higher and more immediate rate increases has brought forward the futures market’s pricing of a Fed Funds rate cut forward into early 2023.  The other reason for the good performance of equity and bond markets in July was, as we alluded to in the July mid-monthly update, a lot of bad news and pessimism being priced in.

Sharply lower bond yields were a boost for quality growth businesses’ share prices due to the lower discount rate effect.  Many robust quality growth businesses’ share prices were crushed in the growth sell-off earlier in the year.  Their relative cheapness to their peers and acquisitors has led to a warranted rebound in performance.

Signs of slower growth were encouraging too for those predicting a Fed turnaround in Q1 2023.  Second quarter US Gross Domestic Product (GDP) data published in the last week of July, confirmed a technical recession in the US after two negative quarters of GDP growth. The US prefers a broader definition of recession as defined by the National Bureau of Economic Research (NBER).

Source: Bloomberg

Despite the negative growth backdrop, second quarter earnings were slightly better than forecast.  However, future earnings forecasts have been pared back from optimistic levels, especially in the US.

Are We There Yet?

While it was refreshing to witness the rebound in risk and ‘risk-free’ (developed market government bond markets) in July, much was due to a rebound from oversold levels and expectations of over-zealous tightening by the US central bank leading to an early reversal of monetary tightening in 2023.  For the Fed and the Bank of England to change course from monetary tightening, they will need to be reassured that tight labour markets ease and unemployment rises taking the pressure off wages and preventing a wage/price spiral.  The graph below from Absolute Strategy Research illustrates the Fed’s dilemma:

But ‘better’ news on employment from the Fed’s perspective may be coming from jobless claims. Second quarter earnings season continued in the US with generally positive outcomes or at least, not as bad as expected.  There were multiple references to inflation in companies accompanying statements.  There were also numerous references to a freeze on hiring or lay-offs.  In a tight labour market, it was also interesting to note the increase in US unemployment claims for the third week running to an eight month high:

Source: Bloomberg

Additionally, supply chain issues appeared to be receding in the US according to the Richmond Fed as the following chart sourced from The Daily Shot demonstrates:

Source: The Daily Shot

There could be good news ahead on UK inflation from previous overstocking of inventories:

Source: The Daily Shot

Summary

Equities had a sharp rebound in July led geographically by the US where the previously lagging Nasdaq, topped the major indices.  Asia ex-Japan, which had seen a resurgence in May and June proved to be the laggard in July.  Thematically, climate change related equities and associated materials enjoyed double digit returns in July.

Debt markets fared well in July led by government bond yields tumbling in Europe and the US in response increased recessionary risks.  After the mid-point of July, non-government spreads rallied to close narrower over the month as a whole.  The exception was ‘emerging market’ debt which although better from mid-month, failed to recoup earlier losses.  Within Europe, political upheaval from Italian Prime Minister Draghi’s exit, caused a widening of spreads to their German counterparts.

In currency markets, the US dollar’s strength abated mid-month with most developed market currencies ending the month stronger against the US dollar than at the outset of July.  The previously under fire Japanese yen rebounded strongly. Even Bitcoin rallied from its depths although overshadowed by Ethereum’s bounce.

Commodities also evidenced a month of two distinct halves but were generally weak from softs to metals through to oil in July.

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