August 2022 - Monthly House Views
Of inflation fears and recession worries
The latest minutes of the Bank of England’s (BoE) Monetary Policy Committee make for a grim reading. Inflation, they now forecast, is likely to continue rising past even 13% towards the end of this year, a significant revision of the economists’ previous expectations in May (“averaging slightly over 10% at its peak in 2022 Q4”) and February (“peaking at around 71⁄4% in April”). In a continued effort to curb price pressures, the committee voted for a 50bps rate hike, the largest increase in 27 years, taking the BoE base rate to 1.75%. Engaging in ever more aggressive tightening, policymakers expect to return price growth to its 2% target in 2024, but not without pain: the UK economy is set to enter a recession in Q4 of this year and will likely remain on a negative growth trajectory until Q2 2024.
Ironically, equity markets rose on the news. The FTSE 100, UK’s bellwether equity index comprising the 100 largest companies, closed up 0.2% on the day. Its small- and mid-cap cousin, FTSE 250, even rose 0.7%. Investors, residing between a rock and a hard place, shifted their focus from inflationary concerns to growth ones, betting that a deteriorating economic outlook would force the BoE to “take the foot off the brake” sooner rather than later.
The central bank’s policy action gained some traction in cooling down aggregate demand in the domestic economy; however, it fails to meaningfully impact the exogenous factors driving much of the lingering consumer price pressures – notably from energy – which are likely to remain elevated in the short term. This, investors reckon, will give central bankers pause heading into 2023: why risk excessive pain to households and firms if the remaining factors are largely outside the BoE’s control?
Meanwhile, head across the pond to find a radically different narrative. Posting a second quarter of negative GDP growth, the US economy has technically entered a recession already. However, exceptionally strong economic data has caused experts to dispute the appropriateness of this label. Indeed, the labour market remains blistering hot: employers added 528,000 jobs in July, more than twice the 250,000 expected by analysts, pushing the unemployment rate to 3.5%, its lowest level in more than 50 years! Moreover, the gaping employment chasm first opened with the advent of the pandemic in March 2020 has finally closed, with all 22 million jobs lost now recovered. In addition, average hourly earnings rose 5.2% from the same time a year ago, not sufficient to offset consumer price inflation – which slightly decelerated to 8.5% at the headline level in July, but strong enough to raise concerns of the dreaded wage-price spiral the Federal Reserve (Fed) aims to avoid at all costs. As a result, policymakers are likely to continue their aggressive tightening path, raising rates again sharply by 75bps at their next meeting in September. Nonetheless, the Fed’s forecasts for GDP growth remain positive in the medium term: 1.7% in 2022, followed by a steady but positive 2% in 2023 and 2024.
Joining central banks in their fight against inflation, governments have sprung into action as well. Policies are underway to curb price pressures in the short term, such as Germany’s discussion around re-activating or prolonging the operations of nuclear power plants; or in the medium term, such as the US Democrats’ Inflation Reduction Act, aiming to reduce the costs of prescription drugs and transition to sustainable energy sources. While producing a relatively small impact in and of themselves, these measures should support the peak inflation narrative in Western economies, raise consumer sentiment and tame somewhat the ongoing wage-price spiral.
Nonetheless, deep uncertainties abound. Signs of peaking inflation are mounting in developed economies, though some items continue to give cause for concern: cost of shelter is likely to remain elevated in the short term as increasing central bank rates feed their way through the system. Energy prices, particularly in Europe, are vulnerable to highly unpredictable geopolitical factors and are likely to heavily weigh on consumer sentiment coming into autumn and winter. The runway for a soft landing – disinflation with no recession – remains exceptionally narrow and the risks of policy error are high.
Cumulative Change in US Monthly Employees on Nonfarm Payrolls (Millions of People)
March 2020 - July 2022
Source: Bloomberg, Bureau of Labor Statistics, data as at 31 July 2022
The economic outlook remains in slowdown judging by the forward-looking indicators we measure. While this is favourable for risk assets for the time being, the index has been trending downwards for several months and is at risk of deteriorating further as interest rate spreads narrow.
Valuations have risen as equity markets staged a relief rally and analysts have begun revising earnings expectations in response to deteriorating economic conditions. Nonetheless, valuations remain below their all-time highs of their own recent history.
Momentum for equities remains negative by the 10-month moving-average metric that we favour. This is cause for caution.
Sentiment in markets remains overbearish, as equity fund flows remain subdued and the dollar expensive. Usually this would be a buying signal but when paired with negative momentum and a precarious economic climate, it is best to not act just yet on this signal alone.
Given the radical uncertainty facing markets we prefer a prudent positioning having recently moved underweight equities and expanded duration with a stable of diversifiers in the mix, including cash, government bonds and hedge funds. This provides a resilient positioning in the wake of elevated volatility and sufficient flexibility to adjust our views should conditions change: to further cut risk in case of a deteriorating economic environment or add to it should momentum turn or if rate hike cycles prove to be drastically overestimated.
Process and Convictions
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Unless otherwise specified, all statistics and figures in this report were taken from Bloomberg and Macrobond on 05/20/2022.