It’s been a relatively quiet week for news, so rather than looking backwards over the events of the past few days I will look forwards to the final quarter of 2023
That said, it is interesting to note the “risk off” tone of financial markets, with equity momentum stalling and bonds reacting negatively to the “higher for longer” narrative that emerged from the central bank meetings last week.
The economic data we have seen this week has generally been disappointing, with the highlight being the flash PMI data which softened across the US, UK and eurozone. In the US the composite PMI eased to 50.1 (the PMI is a diffusion index, with any level above 50 indicating expansion and anything below pointing to contraction); services data also remained positive at 50.2, but this was the lowest level since January. Meanwhile, the US consumer confidence data for September was weaker than expected, falling to its lowest level since May. Is the US consumer finally running out of steam?
Elsewhere, the UK and eurozone composite PMI data remained in contraction, with the UK services sector in particular showing a marked deterioration. We will see the full PMI data next week, but the flash data certainly suggests declining economic momentum as Q3 concludes.
As September draws to a close, we have the opportunity to look forward to the final quarter of the year, and can reflect on what has been a stronger-than-expected year for western economies. No doubt economic data is on a weakening trajectory, but at the start of the year we anticipated economic growth would be considerably weaker than has turned out. Growth in the US remains solid, and although it is significantly weaker in the UK and eurozone it remains positive.
So, why have economies continued to grow despite significant monetary headwinds in the form of rapid hikes in interest rates? A common theme across the US, UK and eurozone is consumer resilience, in spite of higher food and energy bills and housing costs for those that have had to refinance their mortgage or pay higher rental costs.
It is clear that the pass through from higher interest rates has had a longer lagged effect than in previous cycles. This is thanks to mortgages being held by a lower percentage of households, while those with mortgages have generally fixed for at least two years, meaning a lower proportion of households have had to feel the pain of higher interest rates.
In the US the mortgage market is very different, with mortgage terms of generally 30 years – great if you are settled in your property, not so good if you need to move house and take out a new mortgage. The main factor helping consumer resilience here is the pent-up savings and transfer payments from the Covid-19 pandemic.
Across western economies, consumers have been able to draw down on these excess savings over the past 12 months, which has substantially cushioned the impact from the rising cost of living. Of course, these savings won’t last for ever, and a key factor in our view that consumption will weaken over the coming months is data showing these savings are close to being exhausted.
Labour markets have also shown considerable resilience this year, with unemployment rates creeping higher but not at a pace to weigh on consumer sentiment. Leading indicators on job openings and temporary staffing, however, suggest we will see unemployment increase as we move into 2024.
We should also remember that this time last year the world was in the midst of an energy crisis. Consumers in many countries, particularly in Europe, were sheltered from the worst of the price spikes thanks to costly government intervention, something that is unlikely to be repeated given the expense involved. While this year has seen a huge number of weather-related events, the mild winter in the northern hemisphere was a significant contributor to a more benign outcome in terms of limiting the impact of higher energy costs on economic activity.
So far, 2023 has been a year where, for a variety of reasons, the consensus view on economic growth has proved to be wide of the mark. We have seen the narrative shift between “hard landing”, “soft landing” and “no landing”. While it is clear that recession calls have been incorrect, that does not mean we are on the cusp of a period of economic strength. Indeed, the aggressive rate hiking cycles seen in the UK, US and eurozone are yet to fully impact economies and there is enough evidence in the leading data to suggest the coming quarters will see a decline in economic momentum, which in some economies could be enough to push growth into negative territory for two quarters – thus meeting the “recession” definition.
A key point is that there is potential for differentiation as economic trajectories diverge, given central bank policies are unlikely to move in lockstep over the coming quarters. Central banks in the UK, US and eurozone are very much aligned in that they are “data dependent” and reserve the right to raise rates further if inflation proves persistent. The market view is that rate hikes are pretty much done, and history suggests the top of the rate cycle rarely lasts more than a few months before cuts follow.
Is it different this time? Central banks think so – their forecasts suggest inflation will remain a challenge for some time and, as such, they have suggested that rates will remain at current levels for an extended period. It seems likely, however, that if we see economies rolling over, central banks may well need to change their policy outlook. This, of course, assumes that the lagged impact of the past 12-18 months of rate hikes feeds into an economic slowdown, as history and economics textbooks would suggest.
We do see the economic headwinds increasing and are cognisant that if we do escape a recession and settle in “soft landing” territory, that may well mean rates need to stay elevated for even longer to ensure inflation is defeated. While it may mean some short-term pain, the clearing event of an economic and earnings recession which brings about interest rate cuts could prove to be a more positive “reset” than a prolonged period of sluggish growth, higher inflation and elevated rates.
But we all know there is a political element to this, and avoiding recessions helps your chances of re-election. There will be a US presidential election in November 2024 and a UK general election by January 2025 at the latest. In the US, one reason why the economy has been so robust is the growth in government spending over the past 12 months, with President Biden extremely keen to push out any recession beyond 2024. The US is also on the brink of another government shutdown thanks to a failure to agree a budget beyond the end of this month.
In the UK, Rishi Sunak would likely be very happy to boost spending to help his own re-election chances, but the bond markets are very unlikely to be accommodative of higher government spending, not least when the debacle of last September is still fresh in memories. The Autumn Statement is expected to deliver, via the Office for Budgetary Responsibility, a sobering assessment of the growth outlook and the public finances, leaving the government little room to manoeuvre.
Where does this leave us? We continue to have a relatively cautious view of the world, but as always need to balance macroeconomic fundamentals with a view of whether that news is “in the price”. Valuations generally do not look particularly cheap, not least in the US where we remain underweight. We do think the UK, despite poor macro fundamentals, looks more attractive from the bottom up, and valuations are more compelling. Japan is also a country where we see decent fundamentals and reasonable valuations despite some decent gains already this year.
We think the relative attraction of Asia, emerging markets and Europe is poor, not least given that China appears comfortable with weaker economic growth rather than significant stimulus – likely a prudent policy move in the long term but one that means it is hard to get too excited about China and the wider region for now. The impact of a slower pace of growth in China is also likely to weigh on the European economy given China is (was?) such an important export destination. We continue to be underweight in equities, preferring bonds and, to an extent, cash and gold. Our bond positioning and our overweight in duration has not worked in recent months but we do expect this to bear fruit as the economic data weakens and it becomes clearer that the next move for interest rates is lower.
Navigating 2023 has not been simple, and we do not expect our job to get any easier given the levels of uncertainty around the economic, political and central bank landscape. Given the very sanguine, near complacent, mood in financial markets until the past few weeks, we do think we will see volatility pick up, but that is no bad thing for the opportunistic and stock picking managers we seek to invest in on your client’s behalf.
We will explore these issues and more in our upcoming webinar on 12 October. Please click on this link to book your place.
Have a good weekend, kind regards,
Anthony.
