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Stocks fall as economic data declines

Please see below ‘Markets in a Minute’ article received from Brewin Dolphin yesterday evening, which provides a global market and economic update.

Most major markets finished in the red in a week that saw worse-than-expected economic data from the UK and Germany.

In Europe, the FTSE 100 lost 1.9% as UK inflation rose by a higher-than-expected 8.7%. Pan-European Stoxx 600 lost 1.6% as the German economy contracted 0.3%, taking it into recession.

Over in the US, the S&P 500 rose 0.3% and the Nasdaq added 2.0% as hopes were raised of an agreement on the debt ceiling and optimism over artificial intelligence boosted chip stocks. Meanwhile, the Dow lost 0.6%.

Asia saw all markets decline due to concerns of the US debt ceiling despite a boost in tech stock.

Food inflation falls in May

The FTSE 100 dropped 1.38% on Tuesday (30 May), as UK shop price inflation rose to an annualised 9% in May, up from 8.8% in April, the highest rate in 18 years, according to the British Retail Consortium (BRC).

The BRC announced Tuesday that annualised food inflation fell to 15.4% in May, declining from 15.7% in March. The decline is driven primarily by a fall in energy and commodities costs.

UK inflation remains persistently high

Figures from the Office of National Statistics released last week showed that the UK Consumer Price Index (CPI) rose by an annualised 8.7% in April, down from 10.1% in March and higher than a predicted 8.4%. Falling energy and gas prices contributed to the decline but remain a main driver of inflation alongside food and non-alcoholic beverages. On a monthly basis, CPI rose by 1.2% in April compared to 2.5% in April 2022.

Core CPI (excluding energy, food, alcohol and tobacco) rose by 6.8% in the year to April, up from 6.2% in March, the highest level in over 30 years.

The higher-than-expected inflation figures have led to a sharp decline in bonds, as investors expect the Bank of England (BoE) to raise interest rates further this year. The yield on two-year gilts rose to 4.4% on Wednesday last week, up from 3.7% earlier in the month. Yields rise when bond prices fall.

UK mortgage costs rose by up to 0.45 percentage points at the end of last week, with rates on fixed-rate deals now reaching 5.0% and over. The average two-year and five-year fixed-rate deals are now 5.63% and 4.80% respectively, according to USwitch.

Mortgage lenders have pulled nearly 800 residential and buy-to-let mortgage products from the UK markets in the anticipation of further interest rate hikes, figures from Moneyfacts show. Residential mortgages have fallen by almost 7% in a week, while buy-to-let products have dropped by more than 14%.

Chancellor Jeremy Hunt said on Friday that he was comfortable with the UK entering a recession if this would help bring down inflation, and that he would support the BoE raising interest rates, even as high as 5.5%, to stifle price growth.

UK retail sales volumes rise

British shoppers increased their spending last month as UK retail sales volumes grew by 0.5% in April, rebounding from a fall of 1.2% in March.

The non-food stores sector was boosted by strong performance in the other non-food stores sector, which saw 2.1% monthly growth thanks to strong sales of watches and jewellery and sports equipment. Clothing store sales volumes grew by 0.2%, while household goods fell by 0.2%.

Food store sales rose by 0.7% following a fall of 0.8% in March. Automotive fuel sales volumes fell by 2.2% in April following a 0.1% rise in March.

On a quarterly basis, sales volumes rose 0.8% in the three months to April compared to the previous three months, the highest rate since August 2021.

US debt ceiling agreement reached

US president Joe Biden and House of Representatives speaker Kevin McCarthy have agreed to suspend the US debt ceiling into 2025. The deal would see non-defence spending remaining roughly flat in 2024 before increasing by 1.0% in 2025. Defence spending would increase to $886bn, in line with president Biden’s previously proposed defence budget. The White House estimates that government spending would be reduced by at least $1tn, but no official calculations have been released yet. Most of these savings would come from capping spending on domestic programmes for housing, border control, scientific research and other discretionary spending.

The deal will need to be approved in the House of Representatives and the Senate before 5 June, when the US could default. While some lawmakers are expecting the deal to go through, several Republicans have publicly stated they will vote against it.

The deal has faced bi-partisan criticism; Republicans have argued it does not go far enough to reduce spending or target Biden’s student loan forgiveness plan, while Democrats have targeted the inclusion of work requirements for federal assistance.

Germany enters recession

Germany has entered a recession as the economy contracted 0.3% between January and March, according to government figures. The figures follow a 0.5% contraction in the final quarter of last year. A recession occurs when a country’s economy shrinks for two consecutive quarters.

Germany’s annualised inflation rate hit 7.2% in April, exceeding the eurozone average rate of 7.0%.

An increase in private sector investment and construction at the start of the year was offset by a decline in consumer spending. Household spending fell by 1.2% in the first quarter, as consumers reduced spending on food and beverages, clothing and footwear, and furnishings. Government spending also decreased by 4.9% compared to the previous quarter.

Please check in with us again soon for further relevant content and news.

Chloe

01/06/2023

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Tatton Investment Management – Tuesday Digest

Please see the below article from Tatton Investment Management providing a brief analysis of the key news from markets over the past week. Received this morning – 30/05/2023.

Overview: debt ceiling angst, or simply a lack of good news

Last week brought another bout of equity market volatility, with much of the blame for the market wobble attributed to the US government debt ceiling negotiations. The deadline after which the US government runs out of money – and technically defaults on its financial obligations – is now likely only 5-10 business days away, so market nervousness ahead of such an impending – and portentous – deadline is wholly understandable. Over the weekend an agreement between Democratic and Republican party leadership was reached, although the House of Representatives must vote on Wednesday before sending the bill to the Senate. It could therefore still go right down to the wire.

The other big – and to our mind more important – move of last week took place in the bond market, with a sell-off moving yields higher again, in some instances, like the UK, reaching levels not seen since last autumn, after the Truss government’s ill-fated mini-budget. Indeed, last week’s step up in bond yields came at the same time as inflation reports (such as in the UK) showed that inflation – while trending downwards – is nevertheless proving sticky and persistent. At the same time, Germany was reported to have been in recession over the winter quarters and China’s COVID recovery has disappointed this far against the high expectations earlier in the year. Against this backdrop, expectations of central banks reversing their rates policies have been further pushed out towards the end of this year and even the first quarter of next year, while expectations of resurging economic growth over the second half of this year have been dampened.

It is unsurprising then, to find the investment community increasingly polarised on the outlook. There are many strong arguments pointing towards an eventual downturn – even if that only takes place next year – and equally good reasonings why the global economy might just muddle its way through the downdraft forces of 2023, and keep going forward for longer than conventional economic theory would otherwise suggest. For those already looking beyond the likely resolution of the debt ceiling cliff, the next market threat will likely be the impending liquidity drain caused by the US government which must replenish its empty coffers by issuing $1 trillion of new bonds into markets. But there may be some reassurance that most of the $2.4 trillion of cash currently deposited by US money market funds in the US Federal Reserve’s Reverse Repo facility is expected to be attracted by the higher rates the US government will have on offer than the US central bank. Perhaps this insight better explains some of upbeat market sentiment on Friday than the positive vibes from the debt ceiling negotiators.

New EU fiscal rule changes loom large

While last week’s sobering announcement that Germany was officially in recession through the winter was worrisome, Europe’s problems could undoubtedly have been much worse. Given Germany’s (and Europe’s in general) previous dependence on Russian energy, a bleak winter would likely have resulted in widespread production shutdowns. In the end, a combination of milder weather which supported construction spending, the faster establishment of liquified natural gas (LNG) supplies from North America and better-than-expected energy storage meant the eurozone emerged without an overall contraction of growth. At least so far, although the recent German numbers are likely to weigh on revised eurozone growth performance – nevertheless, a decent result all things considered.

Even Greece – the epicentre of past euro crises – is on course to regain its investment-grade credit rating this year. It is already the fastest-growing economy in the bloc, and the unexpectedly big election win for Greece’s centre-right government recently pushed bond yields down dramatically, in a further sign that markets are regaining confidence. But before too much credit is claimed by Europe’s technocrats, in truth, the Greek story is far from a success of European policy. Strict budgetary rules have hindered growth and after a decade of public spending cuts, tax rises and reforms – much of it at the behest of the troika (the European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF) combined) – Greece’s debt-to-GDP ratio remains worse than in 2012. Its economy, meanwhile, is still smaller than it was in 2008.

The EC is currently drafting proposals for reforming the bloc’s fiscal rules, which it argues even more urgently must be updated in light of the pandemic and Europe’s energy supply crisis. It wants to reappraise debt-to-GDP targets which prohibit national debt from exceeding 60% of GDP and the annual fiscal deficit from going above 3% of GDP. Its original proposals were for bespoke plans for each nation, similar to the IMF’s national lending agreements (of course without disbursing any money).

Germany and the Netherlands have opposed such tailor-made plans, arguing there must be minimum targets for indebted countries. They suggest numerical targets are the only way to ensure tangible progress on debt reduction, and point out that the existing rules are full of exceptions for economic hardships anyway – as evidenced by historical adherence to the rules. Proponents of the tailor-made approach, though, argue countries would be much more likely to stick to the rules if they were bilaterally agreed, instead of imposed by central diktat. This could also avoid pro-cyclical policies which demand austerity through tough economic periods and spending in times of growth. That could be a big help for nations that might need more time to implement budget adjustments. Fiscal transitions, and especially structural reforms, can be very costly at the beginning, as some industries might need to be closed or reformed, while productive infrastructure is put in place.

Something policymakers will not openly discuss, but are very likely worried about, is that a lack of common rules might lead to preferential treatment for certain countries. However, even under the new framework, bespoke repayment plans have to be approved by the EC, meaning national governments have the final say. If some such budget can be established by the end of June (when negotiations heat up) that would be a transformative, though unlikely, step. Whatever formal framework is agreed, it is most likely going to be through a typical European compromise – enforcement and genuine progress will (as usual) come down to goodwill and political engagement.

Please check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Alex Clare

30/05/2023

Team No Comments

Invesco – Market volatility expected to rise as US debt ceiling debate continues

Please see below an article published by Invesco earlier this week which covers their views on how the ongoing negotiations on the US debt ceiling continue to impact on markets and what the potential outcomes are:  

US debt ceiling negotiations are occupying an increasing amount of investor attention as we get closer to the “X-date” — the date that the US government is expected to run out of money to fully meet its financial obligations. Currently, the X-date is estimated to be June 1.

Late last week, the stock market moved from complacency to fervor around the debt ceiling situation – reports that the parties were getting closer to an agreement sent stocks higher. I was skeptical because there seemed to be such a significant gap between the Biden administration’s position and House Republicans’ position. Yes, Democrats and Republicans had agreed to a clawback of COVID-related stimulus that has not been spent yet. And yes, the Democrats had eased their position on work requirements for welfare-related benefits, saying they were open to some requirements. But that was the easy part. The far bigger issue is discretionary spending cuts, where the chasm between Democrats and Republicans is wide.

Both parties agreed to ringfence Social Security and Medicare with no cuts or even caps applied, and only focus on other types of discretionary spending. The Republicans’ bill, passed in April, would reduce discretionary spending to fiscal year (FY) 2022 levels and limit the growth of future spending to 1% annually over the next 10 years. The White House has proposed keeping spending at FY2023 levels into FY2024, but they want the defense discretionary spending to share in some of those cuts. And so my skepticism comes from the wide gap in bargaining positions: Republicans want 10 years of cuts on discretionary spending while Democrats want two years of caps.

And so it is no surprise to me that, in the last several days as the tough decisions on spending get hammered out, the negotiating parties have gotten more pessimistic. It’s just more realistic, in my opinion. And it suggests to me that we’ll see more market turbulence in coming days.

So where do we go from here?
 

Three scenarios for resolving the debt ceiling debate

Compromise. The most likely scenario is that the two parties arrive at a compromise. That probably wouldn’t happen until the 11th hour, as we have seen in past debt ceiling negotiations. And it will not be easy. In order to meet the X-date deadline, Speaker Kevin McCarthy says a negotiated draft bill must be received by the House Rules Committee by Wednesday the 24th, as it will not be able to receive a vote for 72 hours. After a Saturday vote, the Senate would then have four days to process the bill by regular order. There is a path in the which Senate can process the bill in a condensed timeframe, but that is a narrow strategy and less reliable.

One of the concessions McCarthy made in order to win enough votes to be elected Speaker of the House was restoring the ability for any single member to call for a “no confidence” vote on him. Such a vote would be unlikely to ever unseat McCarthy, but it injects one more possible headache into the negotiating process because there is no cooling off period after a “motion to vacate” vote, so another one can be called the following day, and so on. Suffice it to say it would be very disruptive.

Discharge petition. A second possible scenario is that Democrats utilize a discharge petition to raise the debt ceiling. This is not a layup, however. A discharge petition is a parliamentary procedure to bring a bill out of committee and to the floor for a vote without the committee’s approval to do so. This forces the House to take action on a bill even if the Speaker or the committee it originates from objects. On May 17, House Democratic leadership filed a discharge petition to move a bill for a clean debt ceiling increase out of committee, and 210 Democratic House members signed it. However, Democrats need 218 signatures to force a vote on the floor, which would require some Republicans to sign the petition — and thus far all Republican members of Congress have remained aligned with Speaker McCarthy. And even if Democrats could force a vote, the earliest date that could occur would be June 12 – almost two weeks after estimated X-date.

The 14th amendment. The third possible scenario is that the Biden administration invokes the 14th Amendment — an option they’ve been reluctant to use. The 14th Amendment of the US Constitution states that “the validity of the public debt of the United States, authorized by law…shall not be questioned,” which is widely interpreted to require the US government to meet its financial obligations. The idea here is that the White House and Treasury could decide to keep issuing debt in order to honor past obligations, no matter what happens with the debt ceiling. However, the US Constitution also allocates budgetary power to Congress, not the Executive Branch. Thus, using the 14th Amendment to keep issuing debt would certainly face a legal challenge from Republicans and could get caught in the courts for years. And so it seems the Biden administration is not interested in utilizing this to resolve the debt crisis unless the US arrives at the X-date without the debt ceiling being raised. Another interpretation of the 14th Amendment is that it rules out default, and since it’s part of the Constitution, it stands above the budget law — and this together with the need to maintain financial stability means that the Treasury would have to prioritize debt payments.

News around the world

While the US debt ceiling debate has captivated market observers, there have been plenty of notable developments around the world:

  • China. April economic data for China came in below expectations. For example, China retail sales rose 18.4% year over year, which was well below consensus.1 And manufacturing-related activity has been disappointing, although that is likely a reflection of the global economic slowdown. It seems that the Chinese economy is continuing to experience significant growth in services activity, but it is not generally as strong as expected. I continue to believe the China re-opening has very long legs – it’s just taking a breather.
  • Canada. Canada’s Consumer Price Index (CPI) print for April was higher than expected, and modestly higher than March. While it’s moving in the wrong direction, some of that increase can be attributed to the Bank of Canada’s rate hikes, which have driven up mortgage rates and increased the cost of shelter. More importantly, I continue to believe one print does not change the narrative. Canada is in a disinflationary trend; however, it is imperfect and lumpy. I don’t think it should force the Bank of Canada to abandon its conditional pause.
  • Japan. Japan also saw significant inflation in its most recent CPI print. The good news is that Japan is also experiencing strong growth, as first quarter gross domestic product came in well above expectations. It does beg the question of when the Bank of Japan will get less dovish.
     

Looking ahead

In terms of investment implications, we are getting conflicting reactions from the stock and bond market. The bond market is pricing in the risk of a technical default, with yields on T-bills maturing in early June rising dramatically. However, the stock market seems far more optimistic, and is not pricing in that risk; even the VIX is relatively low. My read is that the bond market usually errs on the side of greater pessimism while the stock market is often irrepressibly optimistic.

I think the bond market is the more accurate measure of risk right now, and that a brief technical default is a real possibility. Stock markets are likely to reflect that greater risk as we get closer to the X-date without an agreement in place. I just believe a technical default would likely be very brief, as it would provide the impetus for the parties to finally reach an agreement and end the standoff.

And so I have to say that I’m looking forward to reaching mid-June, a time when I feel confident that the debt ceiling impasse should be behind us, one way or another. Perhaps we should think of this spring’s debt ceiling crisis as just a financial form of allergy season: It’s going to get worse before it gets better, and we just need to ride it out until pollen counts go down and we can get back to normalcy. I think we’ll all be able to exhale by mid-June, although it will likely be an increasingly volatile market environment between now and then.

Once that drama recedes, I think all eyes will be back on central banks. I’m optimistic that the US Federal Reserve and the Bank of Canada will maintain conditional pauses, and that other Western developed central banks will draw closer to the end of their respective tightening cycles. I think markets will soon begin to discount an economic recovery, even though sentiment is very pessimistic right now.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Carl Mitchell – Dip PFS

Independent Financial Adviser

26/05/2023

Team No Comments

EPIC Investment Partners

The Daily Update: Qatar Economic Forum

Please see the below article from EPIC Investment Partners providing a Daily Update regarding the Qatar Economic Forum. Received this morning 25/05/2023.

With over 2,000 participants expected to attend the Qatar Economic Forum, half of which are expected to come from overseas, Qatar looks to be placed firmly on the global stage. Topics including, but not limited to, inflation, investing in emerging markets, energy transformation, trade, AI, sports events and geopolitics, all in the name of economic growth, are all expected to be discussed and debated.

Having been very active in the credit space over the past couple years, the nation’s wealth fund CEO Mansoor Al Mahmoud said Qatar Investment Authority is “keen to do more as companies with good business models struggle with the double whammy of interest rates and low liquidity”. He added that traditionally such liquid investment institutions have a “very long-term risk” appetite for such investments, adding that “for the next one year … the credit space is an interesting place to deploy some investments.”

Al-Kaabi, the nation’s minister for Energy Affairs and CEO of Qatar Energy, once again reiterated his concerns over shortages in oil and gas supplies amid the global push toward greener energy sources. He highlighted Europe in particular, saying it managed its energy conundrum due to mild weather and slow economic expansion, but warned “only a warm winter can save Europe this year”. He stated that the lack of future investment in gas and oil, the fuels required for the energy transition, will create shortages in both, as resources are deployed elsewhere in the “aggressive” green energy push. He noted the G7’s call for more LNG to be supplied globally, adding that Qatar currently produces 77million tonnes of LNG a year with an aim to increase that to 126mtpa in-line with contracts that have been awarded. He added that they can do more.

Meanwhile, Saudi Arabia’s Energy Minister once again warned oil speculators to watch out, and economist Nouriel Roubini discussed his concerns over market confidence if the US debt ceiling debate continues to drag on. The IMF Chief Kristalina Georgieva echoed our sentiment of a resolution to the debt ceiling: “History tells us that the US will wrestle with this notion of default but come the 11th hour it gets resolved”.

We will continue to monitor key events from the forum this week as keen investors in Qatar’s AA/AA- sovereign and quasi-sovereign debt, which our proprietary models highlight as “wealthy”, “undervalued” bonds.

Please check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Alex Clare

25/05/2023

Team No Comments

Brewin Dolphin: Markets in a Minute


Please see this week’s Markets in a Minute update from Brewin Dolphin received late yesterday afternoon:

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Andrew Lloyd DipPFS

24/05/2023

Team No Comments

Weekly market commentary: Release of Fed’s preferred inflation measure and UK inflation numbers

Please see below article received from Brooks Macdonald yesterday afternoon, which provides a succinct but detailed global market update.

  • Equities rose last week despite the risks of the US defaulting on its debt obligations
  • President Biden and Republican Speaker McCarthy are set to meet at the White House to continue negotiations
  • This week sees the release of the US Federal Reserve’s (Fed) preferred inflation measure as well as the UK’s inflation numbers

Equities rose last week despite the risks of the US defaulting on its debt obligations

Equity markets rose last week as investors shrugged off the impending US debt ceiling deadline, focusing on a constructive earnings season and the likelihood that the US has already reached its peak interest rate for this economic cycle.

President Biden and Republican Speaker McCarthy are set to meet at the White House to continue negotiations

Despite the fact there is still no final deal, and Republican negotiators walked out of talks on Friday, last week saw growing optimism that the US political leadership would find a compromise arrangement to avoid defaulting on US obligations. This helped equity markets to rise after trading in a tight range over the last month given concerns around the US debt ceiling and US regional banks. President Biden and House Speaker McCarthy are set to continue debt ceiling talks at the White House later today. Over the weekend there was a phone call which pointed to a more constructive tone than one would have imagined from the walkout on Friday. With Treasury Secretary Yellen warning that the chances were ‘quite low’ that the US could meet its obligations from mid-June, the stakes are high even if the mood music appears more favourable.

This week sees the release of the Federal Reserve’s preferred inflation measure as well as the UK’s inflation numbers

This week will see the release of the Personal Consumption Expenditure (PCE) inflation data series in the United States. This is the Fed’s preferred inflation measure and will be a major consideration when the Fed meets to determine the US interest rate in June. The University of Michigan will also release its final survey readings on Friday which include the medium-term consumer inflation expectations. The preliminary readings showed that consumer expectations for 5-10 year inflation had risen significantly (2.9% to 3.2%) which if confirmed in the final reading would be a concern to the Fed that is trying to keep expectations closely anchored to its 2% target. The latest UK inflation numbers will come on Wednesday with the market expecting a sharp fall from last month’s 10.1% year-on-year rise to 8.2%. Core inflation is expected to remain quite sticky however, falling from 6.2% to 6% year-on-year.

Despite US, and global, inflation remaining higher than policy makers would have hoped, the market still considers a pause in US interest rates as the most likely outcome. On Friday Fed Chair Powell said that ‘we can afford to look at the data and the evolving outlook to make careful assessments’, indicating that the Fed is in no rush to raise rates given that there is a lag between their previous hikes and the impact on the economy.

Please check in again with us shortly for further relevant content and news.

Chloe

23/05/2023

Team No Comments

Tatton Investment Management: Monday Digest

Please see below, the ‘Monday Digest’ from Tatton Investment Management, providing a brief analysis of the key news from markets over the past week. Received this morning – 22/05/2023

Earnings improvements boost big tech stocks

Last week, equity markets have generally headed higher. The most notable moves were in US stocks, with the large-cap tech names doing very well in aggregate. The Q1 earnings reports have almost all been published and, on a market-cap-weighted basis, developed world stocks have seen a return to earnings growth in the forecasts for the next 12 months. That’s after six months of analysts seeing falls in earnings. In Europe, cyclical sectors have been the winner with real estate the laggard. Still, the 2023 forecast as a whole is muted at just 1%. Companies continue to be hit by higher interest rates, raising concerns that the European Central Bank (ECB) may keep tightening financial conditions through the summer. In the US, retailers have been discussing the continued softening of spending trends for big-ticket and other discretionary items. The pandemic reversal is still releasing pent-up demand for services – particularly travel and entertainment. 

But for both regions, what stands out as surprising is that ‘top-line’ revenues are better than expected. In Europe margins are still under pressure, but sales are substantially improved. In the US, both sales and margins have started to improve. That tallies with a more stable economic environment, especially for Europe where energy price declines have helped greatly. The improvement in global service sector purchasing manager indices (PMIs) also helps explain the corporate positivity.

The good earnings results in the US – and especially Europe – is cause for optimism. Still, the underlying tightness of financial conditions for many companies remains, while the AI theme seems equivalent to a narrowing of profitability breadth on just a limited number of tech firms, at least for the moment. The rise in equity markets is welcome and, if caused by a general improvement in profitability, all the better, but we would feel more optimistic if central banks were less hawkish.

Emerging market currencies suffer a downdraft

The US dollar has moved quite sharply stronger, after some weeks of weakening against most currencies. Conversely, emerging market (EM) currencies – which tend to best reflect the sentiment around underlying EM economies – sunk to a three-week low last Wednesday. The reasons for this pessimism are varied. China’s slower-than-expected growth is weighing on the outlook for EM demand, while financial stress in the US has reduced available capital and hit investor risk appetite. At the individual level, Turkey’s election returned a stronger-than-expected showing for President Erdogan – an unpopular figure with international investors – while the energy crisis in South Africa has deepened. And importantly, South Africa’s geopolitical tension with the US on suspected covert arms exports to Russia has made international investors nervous.

Last week, all but one of the emerging currencies that we follow fell fallen relative to the US dollar (the Brazilian real was unchanged). This suggests the current move may not be about problems in individual nations. It may also be about the US dollar itself. Since the start of the month, the dollar has climbed against both EM and developed currencies. There are signs of a reduction in the supply of dollars held outside of the US – as evidenced by the decline in cross-currency basis swaps (signalling people are willing to pay more for dollars). The amount of dollars available worldwide has fallen, in large part thanks to the continued tightness in US financial conditions. Should this trend continue, it would likely mean the much-discussed bout of dollar weakness could be coming to an end. Indeed, the Citi forex desk has recently cut its losses on their recommendation to be short of the dollar. That would fit with the overall narrative of disappointing global growth and increased risk aversion among corporates and financials. Unfortunately, EMs may have to pay a bigger price than most for all this.

A closer look at the new wave of US bankruptcies

May has been a bumper month for US Chapter 11 bankruptcy filings so far, and this year is on track to be the busiest year for filings since 2010. Many are suggesting this is the beginning of a new wave of business failures – unlike anything seen since the Global Financial Crisis (GFC) of 2008 – with rapidly climbing interest rates, persistently high inflation and slowing consumer demand proving too much to handle. This potent combination seems to have been reinforced by the collapse of several US regional banks over the past few months, causing lenders to rein-in credit and leaving many companies without funding. As noted previously, these problems are unfortunately worst for smaller businesses, which have seen financing costs go up by significantly more than large-caps. However, Bloomberg suggests the current bankruptcy wave is also happening among large and the slew of failures two weekends ago was the biggest burst since Bloomberg started tracking this data 15 years ago.

However, while the total number of US bankruptcies is extremely high, the total amount of debt which is subject to distress is quite low (as a percentage of total outstanding corporate debt). That backs up the idea that it is mainly smaller companies facing difficulties – even if there are lots of them. However, we are certainly not at crisis levels yet, and default rates are currently below past crisis times, and especially below the 2008 level. That is quite remarkable when you consider just how rapidly interest rates have increased over the past year, and the media doom and gloom around the economy – another sign of the US economy’s surprising resilience. We are keeping a close eye on the situation and, if there is any silver lining, it will be that US interest rates will surely stop rising, perhaps falling by the end of the year. But if that does not happen, and rates keep rising, the bankruptcy wave could indeed become a tidal wave.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Alex Kitteringham

22nd May 2023

Team No Comments

Rising interest rates – what happens next?

Please see below article received from Brewin Dolphin yesterday evening, which discusses why inflation remains high, whether a US recession is imminent, and the longer-term outlook.

Why is inflation still high after multiple rate hikes?

Interest rate changes can take a long time to materially affect inflation. Part of the reason is that many loans have fixed terms, where the interest payment does not immediately reflect changes in the central bank policy rate. Rate hikes have started to make an impact, but it will take time for the full effect to be felt.

The extent to which rate hikes influence different inflation categories varies. Central banks exercise a lot of control over house price and rental inflation, as this is a very interest rate-sensitive sector. Rate hikes have already depressed real-world rental inflation, but this takes time to impact consumers as it depends upon when rental agreements are renewed.

Wage inflation tends to be the most important determinant of services inflation excluding housing. The eventual drop in consumer and business spending from rate hikes leads to weaker demand for workers, which then depresses wages. In this sense, rate hikes have a big impact on services ex-housing inflation, but there can be long lags. At present, labour markets in many countries are very tight. For example, in the US there are currently 1.6 job openings for every unemployed worker. This tightness is keeping services ex-housing inflation running strong, notwithstanding the building headwind from higher rates.

Rate rises tend to have a weaker impact on tradeable goods inflation. Food inflation has dropped sharply in recent months in the US, but it remains strong in the UK and other European countries. The Russian invasion of Ukraine, regional weather and its impact on harvests, and foreign exchange movements explain much of the relative divergence in food price inflation in the US and Europe.

When will mortgage holders feel the impact?

It goes without saying that those who are on variable[1]rate mortgages are already feeling the impact of higher mortgage rates. But most households in the US and UK are on fixed-rate deals. Some households on fixed-rate mortgages have already begun to marginally reduce their spending in anticipation of their deals coming up for renewal at higher rates. In its May monetary policy report, the Bank of England (BoE) estimated that higher mortgage rates reduced UK aggregate household consumption by 0.3% in the first quarter of the year. This reduction in spending is being driven by mortgage holders on variable rates as well as those on fixed rates that have already reset.

We would expect that the majority of the reduction in spending will occur when fixed-rate deals actually renew. Roughly 85% of residential mortgages in the UK are fixed, but with terms for the most part at five years or less. The BoE estimates that higher mortgage rates will reduce aggregate household consumption by almost 0.5% by the fourth quarter of 2024. Notably, mortgage terms in the US are generally fixed for a much longer period, often to 30 years.

Another potential impact of higher mortgage rates is an increase in homeowners defaulting on their loans. The extent to which defaults occur will be linked not just to how high mortgage rates go (and for how long they stay there), but also by how the economy evolves. It is safe to say that if unemployment rises substantially, mortgage defaults will increase.

Have rate hikes been more effective in the US?

Several forces have brought inflation down faster in the US than in other regions. For one, the Federal Reserve (Fed) has been more aggressive in its monetary tightening efforts compared to most other central banks. The Fed has so far raised rates by five percentage points. This is above the 4.4 percentage points of hikes implemented by the BoE and 3.75 percentage points of hikes by the European Central Bank.

Meanwhile, until last autumn, the US dollar was strong, which depressed traded goods inflation. Weak European currencies relative to the dollar had the opposite effect. In addition, the inflation stemming from Russia’s war in Ukraine has had more of an impact on Europe. Wage-driven inflation has been a factor on both sides of the Atlantic, as demand for workers has been strong. But the UK has struggled more than most countries with labour supply, with Brexit likely a contributing factor.

What is the relationship between rate hikes and recessions?

Of the 13 Federal Reserve rate hike cycles since the mid-1950s, ten have been followed by a recession that began within a year-and-a-half of the last rate hike of the cycle. While this is clearly a high hit rate, it’s important to note that tightening cycles don’t happen in isolation and are not always the main driver of a recession.

Of the four US recessions that have occurred since 1990, the Fed certainly played a role, but the rate hikes were arguably not the primary cause of any of them. In two of these cycles, a shock rather than rate hikes was the primary cause of the recession. This was the case in 1990, when the economy only went into recession after the oil price spike due to the Gulf War. It was also the case in early 2020, when the recession was all about the Covid shock and had little to do with the Fed’s rate hikes of 2018.

In the other two cycles, the recessions were driven more by the unwinding of large excesses. In 2001, the recession was much more about the contraction in technology-related investment spending than it was about Fed rate hikes. Consumer spending (which represents about 70% of the economy) didn’t decline at all in that recession. In 2008/09, Fed rate hikes certainly acted as a catalyst (as was the case in 2001), but the recession was more about the unwinding of the excesses in banking and housing following a period of very lax lending standards. The main point is that the relationship between rate rises and recessions is not straightforward.

We believe it is more likely than not that the US suffers a recession, with a start date at the end of this year or perhaps in early 2024. But our conviction in this forecast is not high as there are pathways to a ‘soft landing’ (a slowdown in economic growth that avoids a recession). Europe and the UK may avoid an outright recession, but we expect growth to be sluggish. If a US recession does occur, it will likely be mild. A mild recession would limit increases in both the unemployment rate and mortgage defaults. It is also worth highlighting the supply/demand backdrop for housing, which is tight. House prices will suffer as this BoE rate cycle goes on, and to the extent that unemployment rises. But because there is so little supply, that should help to limit the declines. Similar supply and demand dynamics exist to support UK house prices in the face of higher mortgages rates.

What has happened historically after periods of low interest rates?

Central banks hiked rates rapidly in several periods during the 1970s and 1980s, but rates were not low heading into these cycles. Rates were low for a long time following the global financial crisis of 2008, but the subsequent rate hike cycles (2015-18 for the Fed and 2017-18 for the BoE) were very modest. There’s no good historical precedent for the current environment.

Mark Twain’s quote, “History does not repeat itself, but it often rhymes”, is often used to compare economic cycles. As highlighted above, some cycles involve shocks. Other cycles involve the build-up and subsequent unwind of excesses and imbalances. Some cycles see both occur. This cycle has its own similarities and differences with those of the past.

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Chloe

19/05/2023