Surprising developments change the story, but likely not the ending.
News and developments have pointed to interest rates being higher for longer. However, while this has not been helpful for government bonds, our favoured asset class, we don’t see this changing our fundamental outlook and we continue to be neutral on equities, preferring to be cautious and selective.
The risk of a credit crunch in the US has been averted by the Fed’s swift action on the banking crisis. That pushes back our expectation of a US recession and so makes it less certain. However, the revelation of fraud boosting unemployment claims means that the US labour market has actually remained tight, so wages will be back to being the Fed’s main concern. That means the credit squeeze in the US continues, reflecting tightening monetary policy. So, while the news on falling inflation had been positive, the expectation of rate cuts needs to be postponed until wage inflation falls back, still mostly likely as a consequence of a recession.
Elsewhere, UK inflation has provided stickier than expected, but still should be three-point-something by the end of the year, while the German consumer seems to be missing, but is probably just enjoying an extended holiday in Spain. We have updated our charts, but not changed our recommendations.
US
As predicted, the collapse of SVB and mini-crisis in mid-sized US banks caused a sharp downtick in credit availability. But surprisingly, the following survey revealed that this was just a blip. That means that the Fed’s swift action has averted a credit crunch. However, that still leaves a continuing credit squeeze, reflecting tightening monetary policy. Overall, that pushes back our expectation of a US recession and so makes it less certain.
Another piece of data that turns out to have been a blip is the pace of rising unemployment claims in the US. The majority were down to a single state, Massachusetts, where fraud has been revealed. That means that the US labour market remains tight, with wages being the Fed’s main concern.
This is particularly disappointing as our forecast model and the monthly data indicated that the key rental component of US inflation has come off the boil. If the jobs market had been easing at the same time as inflation came down, that could have made for a smoother adjustment to more sustainable wage expectations. While the much-forecast US recession is now further away, we can’t see the Fed doing anything but keeping monetary policy conditions tight until wages ease.
Europe
Some key indicators for the crucial German economy have got worse even as we have become more enthusiastic over the outlook for the Euro-zone economy. However, we see the poor German manufacturing orders as reflecting the current global de-stocking cycle as well as a shift away from investment in energy-intensive industries. Similarly weak German retail sales could reflect a shift to services and experiences over goods, or that German consumers are extending their holidays in places like Spain, where retail volumes are up as much as 10%.
We remain confident that the significant decline of not just current energy prices, but also prices for the next winter, since their peak last year, will translate into lower inflation with increased consumer confidence and spending driving a virtuous circle through the rest of the economy. That European consumers have actually increased savings during the recent squeeze indicates the scope for the recovery.
The ECB will have to continue to increase interest rates. Wages are rising and that is set to accelerate this year as backward-looking indexation kicks in.
UK
Another set of disappointing UK inflation figures has made the Bank of England’s job easier. Another rate rise is now expected for next month, with likely another one to follow. However, the energy price fall and the reversal of sterling weakness means that inflation will fall both at the headline and underlying level. We still expect inflation to be three-point-something by the end of the year.
Lower inflation and an unspent ‘Covid piggy-bank’ mean that the UK consumer will support the economy, just as we see in continental Europe. A recovering economy has also pulled people back into the workforce, supporting growth.
However, each economy is different, and the housing market is a key characteristic for the UK economy. Here higher interest rates are going to continue to overhang mortgage holders, with significant hikes coming through as fixed-term rates come to an end. That headwind will have a bigger drag on UK consumer confidence than in the euro-zone.
We remain confident that the significant decline of not just current energy prices, but also prices for the next winter, since their peak last year, will translate into lower inflation with increased consumer confidence and spending driving a virtuous circle through the rest of the economy. That European consumers have actually increased savings during the recent squeeze indicates the scope for the recovery.
The ECB will have to continue to increase interest rates. Wages are rising and that is set to accelerate this year as backward-looking indexation kicks in.
US equities to underperform, dollar to weaken, bonds to rally
The move from quantitative easing (QE) to quantitative tightening (QT) has had a big impact. We can see that reflected in the risk-free rate, with US 10-year TIPS (Treasury inflation-protected securities) now yielding over 1.4% as opposed to a substantial negative real yield during QE. While recent news on inflation and interest rates have gone the wrong way, we see good value in government bonds at these levels.
While we are overall neutral on equities, we are negative on US equities. That’s not worked at an index level, but it’s been a very narrow rally, with gains on just five stocks accounting for more than all the rally in the S&P 500 so far this year. Company profit margins are being squeezed in the US and there is also the likelihood of a recession. By contrast margins are widening in Europe and we see scope for positive economic surprises as Europe enjoys a virtuous circle of lower inflation and stronger demand.
US interest rates may end 2023 below those in Europe. That will be a dramatic change, the first time that this has happened in the euro’s history, leading to a weak US dollar.
