If you had followed the adage of “sell in May and go away” and done so at the start of the month, returning at the end, you might have concluded that May was something of a non-event for financial markets. Equities and bonds in the US and UK in particular were barely changed in May. Only a rise in the oil price of 10% and a fall in the value of Bitcoin of approximately 17%, would have given any clue to the intra-month volatility that happened in May. The US Nasdaq Composite Index was down just over 2% in May, having been down over 10% at one point. Most developed equity markets were up or down close to 1% over the month as a whole. Japan was one of the better performers, up over 2% in May.
Current monetary policy is about being seen to be doing something (while they can) in the face of steep increases in inflation in western economies and making up for not starting to tighten policy sooner.
As inflation numbers tapered from their peaks in the US, prospects for a moderation in the tightening of monetary policy surfaced, prompting a bounce in risk assets from the market lows of the 24th May, post the release of the Federal Reserve Open Market Committee minutes. Adding to a less negative US inflation backdrop was the release of the US Federal Reserve’s preferred measurement of inflation, Personal Consumption Expenditure.
The Dallas Federal Reserve provides a trimmed version of that statistic, removing the outliers to generate a more consistent reflection of the inflation picture. Here is a snapshot of the analysis sourced from the Federal Reserve Bank of Dallas’s website. The year-on-year rate to April 2022 was 3.8%, up from 3.7% for the same period ending March 2022.
Source: Federal Reserve Bank of Dallas
Fears of a US recession adding to concerns over the Chinese economy’s contraction due to China’s zero tolerance Covid policy had unnerved investors earlier in May. However, US consumer activity has been robust to date, but not without cost as the following graph of the plunging US savings rate illustrates:
Source: NS Partners
The increased cost of living is clearly taking its toll on savings. Higher fuel costs aren’t helping as the following graph sourced from Bloomberg illustrates:
Rising long-term interest rates have understandably had an impact on the US housing market along with high prices. According to the University of Michigan, buying conditions for US houses, have collapsed.
Source: The Daily Shot
Meanwhile, European inflation has yet to peak with the rising cost of food and energy bringing some lofty headline inflation numbers in the mid to high single digits as the following graph of German inflation sourced from The Daily Shot, illustrates.
Source: The Daily Shot
Prospects of two interest rate hikes from the European Central Bank in July and September rattled European government bond markets where ten-year yields rose by up to 0.2% (20bps) in May. Ten-year UK gilts followed suit, breaking above 2% in the process, unnerved by the Bank of England’s tough talk and concerns over even higher inflation in the months ahead. The cost of living hit in most economies is significant and labour market tightness in the UK, where vacancies outnumber those unemployed, is a concern for the Bank of England. The Bank remains concerned that the fall in real wages, due to higher inflation, could transmit in higher wage awards feeding a wage/price spiral as companies pass on the cost of higher wages to the consumer.
For most of May, the US dollar was firm, only moderating after the realisation that the US Federal Reserve’s Open Market Committee’s minutes revealed a more pragmatic approach to monetary policy than the previous tough talk had indicated. Sterling weakness was more a reflection of a stronger US currency.
Industrial metals oscillated with almost the same volatility as other risk assets while gold fell as oil rose in May, helped at the end of the month by greater European sanctions on Russian imports. Soft commodities were also volatile but ended up little changed on the month.
May saw financial asset prices reflect a concern over how high western central banks would hike official short-term interest rates to belatedly address inflation and regain some credibility in the eyes of investors. First signs of inflation peaking in the US and an indication of the US Federal Reserve becoming more pragmatic to avoid a recession later in May, brought about some respite for risk asset prices after a torrid time in the first three weeks of May.
The jury is out on recession possibilities and on US rate hikes but breakeven rates have fallen back as have interest rate futures. Signs of moderating inflation have yet to be seen in Europe and the UK. Higher short-term interest rates are coming at a time when households are being hit by higher food and energy prices. Avoiding a recession in the UK and Europe will be more of a challenge than in the US. China’s zero-tolerance policy to Covid outbreaks should moderate in the months ahead, easing supply chain problems.
Markets will continue to pay close attention to earnings and company outlooks with immediate and significant price moves on any surprises. Quality growth stocks in durable themes such as energy transition, cyber security and infrastructure should fare better after being de-rated since the start of 2022.