The past couple of weeks have seen some upwards momentum in equity markets
With the tail risk of a US debt ceiling crisis removed and exuberance around the theme of Artificial Intelligence (AI) dragging the S&P500 in the US to year-to-date highs as a small number of tech stocks continue to substantially outperform the wider market.
As expected, the US debt ceiling was resolved ahead of the early June deadline at which point the US would have been unable to fulfil all its financial obligations. As I noted several times last month, the expectation in financial markets was that after lots of brinkmanship and posturing a deal would be reached. While the deal may have taken some time to put together, the lack of drama and upbeat comments on progress from both sides meant that outside of short, dated treasury bonds, financial markets were untroubled by the process. That said, the apparent pick up in risk appetite so far this month does suggest that equity market momentum may have been held back by concern that a compromise deal would be found. In terms of the deal, the agreement reached between President Biden and House Speaker Kevin McCarthy means the $31.4 trillion debt ceiling is now suspended until 2025.
This is the 78th time the debt ceiling has been raised since 1960. The US government will cap all non-defence spending next year (defence spending will rise by 3% to $886 billion). The White House has estimated that in terms of the spending cap, it will mean a planned $1 trillion will not be spent. The ‘Fiscal Responsibility Act’ that enshrines the deal passed through Congress with cross-party support. So, the debt ceiling is off the agenda for the next 2 years, but we watch for fallout in terms of liquidity being drained from markets in the coming weeks as the US Treasury rebuilds their cash buffers to the tune of around $1 trillion. The reduction in government spending over the next year will also have economic consequences at a time the US economy is already on a slowing trajectory.
Both the World Bank and OECD updated their economic growth forecasts for 2023, with the World Bank now expecting the world economy to grow by 2.1% this year, an upgrade to their previous forecast of 1.7% made in January. The upgrade is despite the Bank describing the global economy as being in a “precarious state” with stronger than expected resilience so far in 2023 anticipated to fade as tighter monetary policy compounds lingering shocks from the Covid pandemic and Russia’s invasion of Ukraine. The OECD expects a weak recovery from the economic shocks of the pandemic and the Ukraine war, with persistent inflation and restrictive monetary policy weighing on growth. The OECD sees 2023 growth of 2.7% in 2023, rising to 2.9% in 2024, below the average growth rate of 3.4% in the 7 years leading up to the Covid pandemic. The OECD noted the balancing act faced by central banks in resisting core inflationary pressures while not overly damaging economic growth.
Chief Economist Clare Lombardelli said that “the global economy is turning a corner but faces a long road ahead to attain strong and sustainable growth. Policymakers need to unwind the impact of a sequence of negative shocks to the global economy and face a complex set of challenges in doing so”. The OECD said past interest rate hikes are increasingly feeding through, particularly in the property sector and in financial markets but their full effect will not be seen until later this year and into 2024. While the OECD urged central banks to remain restrictive until there are clear signs inflationary pressures are sustainably reduced, they noted this would have an economic impact, and noted that the risks to their forecasts remain to the downside.
In terms of the central banks, it has been relatively quiet, with Federal Reserve members in the ‘blackout’ period ahead of the rate setting meeting next week. The consensus remains that the Fed will pause rate hikes at this meeting, though board members have been at pains to stress that any pause does not mean that they are done hiking rates, indeed a quick look on Bloomberg shows Fed Funds Futures are showing a 26% probability of a hike next week but a 51% probably of a 25-basis point rise in July. The European Central Bank will also meet next week, and anything but another rate hike would be a shock. ECB President Christine Lagarde told the European Parliament earlier this week that “future decisions will ensure that the policy rates will be brought to levels sufficiently restrictive”. Lagarde said that “there is no clear evidence that inflation has peaked” while the ECB minutes from their May meeting highlighted concerns on core inflation with “the latest developments broadly seen as worrisome”, while “members concurred that further tightening was needed”.
The ECB will have taken a little comfort from the flash eurozone inflation data, which for May eased to 6.1%, a 15-month low. There were substantial dips in the pace of inflation across Germany, France, and Spain, though inflation accelerated in Italy. Core inflation, at 5.3% was also lower than expected. Elsewhere in the economic updates, the headline data from the US monthly employment report for May was strong, with Non-Farm Payrolls increasing by 339,000, well ahead of the 195,000 expected. The underlying numbers were a little more soft, with hours worked easing and the pace of wages rises slowing. All the same, the US labour market still appears in decent shape though we should remember that labour is a lagging economic indicator so the cracks in the market may well only appear much later in the year.
The PMI data for the US, UK and eurozone was broadly in line with the ‘flash’ data that I reported on a couple of weeks ago. There was encouraging data from Japan, where manufacturing PMI numbers moved back in ‘expansion’ territory for the first time since last October. We also saw Japanese first quarter GDP revised higher to an annualised pace of 2.7%, a notable increase on the previous reading of 1.6%. Japan – a country of inflation and growth…who would have thought it?! The GDP revisions for the eurozone went the other way, with Q1 growth revised to -0.1% meaning that the eurozone saw a recession over the final quarter of 2022 and first quarter of 2023, albeit a very mild one – a colder winter and persistently higher energy prices would have resulted in a much weaker economic outcome.
In the UK, house prices posted their first year on year decline since 2012, according to the Halifax, with average prices down 1% in May to £286,532. UK mortgage rates have risen in recent weeks as persistent inflation raises the prospect of interest rates staying higher for longer. Markets are pricing almost 100 basis points of further hikes from the Bank of England by the end of the year, which would take the base rate to 5.5%. The average five-year fixed mortgage rate is now just over 5%, having been 4.55% a fortnight ago. The Bank of England has identified 5% as a ‘pain threshold’ for consumers, though the longer dated nature of many UK mortgages compared to even a decade ago means that for some household, the shock of substantially higher mortgage rates is still some time away. This is part of the reason why UK consumption has proved so resilient in the face of the ‘cost of living’ crisis.
In the short term, with confidence/complacency over the path of interest rates helping risk appetite and the tail risks of a debt ceiling breach averted in the US, markets appear in a reasonably positive mood. Expectations for corporate earnings are being revised higher thanks to optimistic assumptions that AI is a ‘game-changer’, which it likely will be for some companies, but the boost to short-term earnings, not least with a recession on the horizon, will only likely impact a narrow list of names. While the S&P500 is at year-to-date highs, up around 10%, taking out the biggest tech companies would see the index flat for the year. This narrow rally is not indicative of a healthy market, and the economic backdrop, with plenty of recession warning flags in the US and anaemic growth this side of the Atlantic, remains concerning.
We continue to expect tougher times ahead in financial markets and chasing returns that are limited to a small number of tech firms, some of which look extremely expensive, does not feel prudent. In an environment of sticky inflation, higher rates, slowing economic growth and weak earnings (but maybe not as weak as feared) for most companies, the market outlook still concerns us, even if in the short term the past of least resistance appears to be higher.
Have a good weekend,
Regards,
Anthony.
