We have seen a very busy week of news with policy change announced at all three major central banks meeting this week, even the Bank of Japan(!).
We have also seen markets digesting a mixed bag of economic data, with PMI data underwhelming but US GDP data helping support the ‘soft landing’ narrative. Meanwhile the International Monetary Fund delivered a ‘less bad’ assessment of the economic outlook; is this a case of recession avoided or recession deferred?
Let’s start with the central banks. The US Federal Reserve increased interest rates, as expected, by 25 basis points, taking the Fed Funds Rate to a 22 year high of 5.25-5.5%. The tone of the statement and press conference made clear that the future path of interest rates will be driven by incoming data. There will be two inflation and employment reports before the next meeting that concludes on 20 September and Fed Chair Jay Powell said that “looking ahead, we will continue to take a data dependent approach in determining the extent of additional policy firming that may be appropriate”. The Fed upgraded their assessment of economic growth from “modest” to “moderate” and Powell noted that the staff assessment of the outlook no longer forecast a recession. Powell said that while Fed officials “welcomed” the June CPI data (where headline CPI was 3%), they want to see a string of softer inflation prints and more signs that inflation is cooling across a variety of leading indicators. The market reaction was very muted – both the rate hike and the data dependent forward guidance was exactly as expected. Looking forward, those aforementioned CPI and employment data points will be used by markets to fine tune their outlook for rates, with expectations balanced between no further hikes and one final 25 basis point hike in September or November. The next question is how long Fed rates remain at the ‘upper bound’ before cuts begin – this is where there remains a large gap between market expectations for cuts to begin within six months, and Fed predictions that rates will remain on hold deep into 2024.
Over in Frankfurt, the European Central Bank also raised rates by 25 basis points. This was the 9th consecutive hike and takes rates to 3.75%. The ECB offered no significant guidance as to what comes next, and this seems to been interpreted as a dovish signal in markets. That said, a 25-basis point hike in September still has a 71% probability per Bloomberg this morning. The ECB statement warned that inflation was still expected to be “too high for too long” and committed to a “data dependent approach” in future meetings. ECB President Christine Lagarde said that the governing council “have an open mind as to what the decisions will be in September and in subsequent meetings” and commented when the ECB did pause “it would not necessarily be for an extended period”.
The Bank of Japan did deliver a surprise even as it kept interest rates unchanged at -0.1%, with Japan the only country in the world with negative interest rates. The change from the BoJ came with their adjustment to Yield Curve Control, the policy which has been in place for 7 years and has kept 10-year bond yields artificially low. The Bank said the cap would be maintained at 0.5% but offered to buy bonds at 1% rather than the 0.5% cap, effectively widening the trading bands on 10-year government debt. Having moved from 0.25% to 0.5% 7 months ago, and now widening the bands further, the BoJ is gradually normalising policy and suggests the BoJ is getting more comfortable that the era of deflation is past even if the inflation currently in the system is driven by specific factors such as food and energy prices. Inflation has been above target for 15 consecutive months in Japan, but ultra loose interest rate policy remains for now with Bank of Japan governor Kazuo Ueda stressing the need for patience with the Bank only considering tightening policy when inflation is more broad based, driven by domestic demand and higher wage growth.
In politics, last weekend’s Spanish general election was inconclusive, with no clear winner emerging in a tighter contest than expected. The incumbent Prime Minister Pedro Sanchez appears set to hang on in power after the opposition centre-right PP won a larger number of seats but fell short of the 176 seats needed to control parliament even with the support of the far-right VOX party. The consensus view is that Sanchez will control a hung Parliament with a fresh set of elections likely in the autumn. In China, the Politburo meeting boosted expectations of stimulus, and lifted the mood in Hong Kong equities, after the summary of the meeting noted “an increased focus on the new difficulties and challenges facing the economy”. Hopes for stimulus are just that for now, but the market interpretation appears to be that the meeting set an encouraging tone for policy easing at some point in the future.
The economic headlines have been dominated by the flash PMI updates – an early reading of the full PMI data for July that will be published in early August. The data was broadly weaker than expected, and with manufacturing remaining weak, the softening in the services data meant that composite data moved closer, or into, contraction territory, represented by a PMI reading below the level of 50. The eurozone composite data was at 48.9, an 8-month low with manufacturing driving the weakness, not least in Germany where PMI manufacturing was at a 38-month low of 38.8. The slowdown in the services sector points to a broadening weakness in the eurozone, which was already in technical recession thanks to negative growth in Q4 2022 and Q1 2023. The UK fared slightly better, with a composite PMI reading of 50.7, though this was a 7-month low, with signs that the resilience in the service side of the economy was beginning to wane, with the services PMI at 51.3, a 6-month low. The UK economy appears to be running just above stall speed based on the current data, and with the lagged impact of rate hikes yet to be fully felt, any improvement appears unlikely in the short term. The data is not consistent with an economic ‘hard landing’ but offers little prospect of a marked improvement in GDP data in Q3. The US economy fared a little better, though the composite PMI of 52.0 does not infer a particularly strong economic backdrop. That said, the better-than-expected GDP data published yesterday at 2.4% annualised for Q2, showed the US economy is still holding up reasonably well, and significantly better than in the UK or eurozone. Further afield, Japan published a similar PMI level to the USA, at 52.1. Japan, however, does not have the lagged impact of rate hikes still to fully impact the economy, which is something that will weigh on growth across the UK, US and eurozone as we go through the second half of the year.
The International Monetary Fund (IMF) made their quarterly update to their World Economic Outlook this week and upgraded their forecast for global economic growth. They now see the world economy expanding by 3% in 2023, up from the 2.8% forecast made in April, at a time when banking system stresses were weighing heavily on minds. The 3% forecast contrasts with growth of 3.5% in 2022 and an average level of growth of 3.8% between 2000 and 2019. The Fund cautioned that we are “not out of the woods yet” as central banks efforts to reign in stubbornly high inflation would still weigh heavily on growth. The IMF noted that the balance of risks are still tilted to the downside but did note upside potential thanks to continued resilience in domestic demand and for inflation to fall faster than expected, reducing the need for restrictive monetary policy. The usual downside risks were mentioned, including from persistent inflation, an intensification of the Ukraine war, and a slowdown in China. The resilience of the consumer was noted as a reason the IMF expects the UK to now avoid recession, with growth of 0.4%. The US is forecast to growth by 1.8%, China by 5.2% and the eurozone by 0.9%. The only major economy now seen as contracting is Germany, at -0.3%.
This will be the last of the weekly market updates for a little while as I take a break for a while and all the joys that a 2000-mile road trip with three kids will bring. iPads, I spy and “are we there yet?” will no doubt be the backdrop to our drive to the Pyrenees!
Enjoy the summer and I shall return in early September.
Kind regards,
Anthony.
