News

Please see below, the ‘Monday Digest’ from Tatton Investment Management discussing the key economic news from the past week. Received this morning – 06/02/2023

Overview: Are central banks transforming from hawks into doves?

If investors were hoping for a turnaround in fortunes, they hardly could have asked for a better start to the year. February began just where January left off: dominated by central bank action, inflation, and despondency over the UK economy. Meanwhile, stock and bond markets stayed buoyant. The monthly US jobs report could have upended the week, but after a brief market wobble, the FTSE 100 ended the week by hitting an all-time high.

Friday’s US Labor Department’s report showed the US economy added an almost unbelievable 517,000 new jobs in January, while the previous month’s data was also revised up. All of a sudden, the big risk to investment markets this year is not so much a global recession, but the robust jobs market. The US employment report was probably not known to the Federal Open Market Committee (FOMC) when its members slowed the pace of rate rises earlier in the week. Last Wednesday, the US Federal Reserve (Fed) raised the Fed funds rate by 0.25% to a midpoint of 4.625%. On Thursday, the Bank of England (BoE) raised the base rate to 4.0%, and the European Central Bank (ECB) effectively raised its short-term rate by 1.0% to 3.0% (0.5% now and another 0.5% in March). However, you could be forgiven for thinking they had all announced rate cuts, given the very positive reactions of both bond and equity markets. 

Given that an end to the current tightening was signalled quite strongly by all three central banks, investors have an increasing belief that monetary policy-driven constraints on profitability are coming to end in the nearer-term. In fact, investors not only expect an imminent peak in US, UK and European interest rates, but think they will start actively loosening monetary policy before the end of the year. With financial conditions loosening, the global economy may already have started its next growth cycle. As ever, though, we suspect one shouldn’t get carried away by waves of positivity. Interest costs are still higher than before, and still have a bit further to go. There are good reasons to think that economic growth may rebound from here, but it feels less plausible that profit growth will be exceptional.

How long is the lag – or why is that lag suddenly shrinking?

We had two reports on the UK economy last week, one from the International Monetary Fund (IMF) and the other from the BoE accompanying its rate decision. The IMF report was depressing reading but was very much in line with the gloomy BoE report published last Autumn, although as is often the case, the IMF report felt out of date. In contrast, at least for the nearer-term outlook, the improving inflation picture allowed the BoE to revise its growth projections up Autumn’s report. 

Inflation optimism is the main reason for the market rally seen this year, and reflects a ‘job well done’ attitude in markets: inflation is or will soon be under control, after which things can get back to normal. But to judge how accurate this view is, we need to know how inflation will develop over the next year and how it will be impacted by monetary policy. Conventional economic wisdom tells us monetary policy has ‘long and variable lags’. In other words, rate hikes or cuts take a long time to filter through to the real economy.

One theory suggests that in the past, interest rates took a while to affect the real economy because the primary mode of transmission was bank lending – an inherently slow-moving process. But over the last decade in particular, such lending has had a much smaller role. Highly-traded corporate bond markets are much more important for businesses, while asset markets are much more important for households (as stock ownership is much higher). These markets are now more sensitive to interest rates and investor sentiment. Moreover, capital markets have become more aligned to monetary policy over the last couple of decades, in part because central bankers are eager to communicate policy far in advance and remove sudden shocks, and in part because forecasting interest rates has become one of the biggest components of any investment portfolio. This results in a feedback loop where investors look for any clues in central bank announcements, and those announcements are tailored for a nervous investor audience.

Shorter lags can be both good and bad. Optimists will say that loosening monetary policy could boost demand before the year is up. If the lag really is long, one could not expect any short-term recovery. If it is short, there is every chance the global economy will improve substantially in the second half of this year. Combine this with the strong growth boost we expect to see from China’s post-COVID re-opening, and we could be in for a decent ride.

The pessimistic view is that central banks might not loosen after all. The current expectation – backed up by comments from its members – is that the Fed now wants to wait-and-see how inflation plays out rather than committing to further tightening. But markets also expect inflation to fall to the Fed’s 2.0% target, and for the US economy to avoid a deep recession. If the policy lag is shorter than expected, those things are unlikely to all be true at once.

Ultimately, the question policymakers have to grapple with is how much growth can be allowed before it becomes inflationary. The structural evidence we have seen post-pandemic – from labour markets and increased regionalisation of global trade – suggests that bar is low. Moreover, if the lag between interest rates and inflation is shorter than expected, central banks will have more incentive to tighten in the short term. Monetary policy transmission is highly complex, but we should not assume that means the job is already done.

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

Alex Kitteringham

6^th February 2023

Please see below article from Evelyn Partners providing an update on February’s Bank of England monetary policy decision. Received this afternoon (02/02/2023)

What happened?

The Bank of England increased rates by 0.5% today at their February monetary policy meeting, which is in line with market and economic expectations. This takes the base rate to 4%, its highest level since 2008, and is the 10th consecutive increase by the Bank. The Monetary Policy Committee (MPC) voted 7-2 in favour of 50bps – 0bps respectively so policymakers continue to have diverse view on the best course for rates, although not as much as the 3-way split seen in December.

What does it mean?

The Bank also published its quarterly outlook on the economy which revealed an upgrade to growth expectations. Gas and electricity prices have roughly halved compared to their November forecasts. Better than expected data in terms of GDP (0.1% for November, relative to expectations of -0.2%), and strong wage growth led the Bank to improve its growth expectations for 2023 to -0.5% from their previous estimate of -1.5% in November. This upgrade has led to a significant reduction in the forecast depth and length of recession facing the UK, with the economy now set to contract by almost 1% over five quarters, rather than 2.9% over eight quarters.

However, in terms of inflation, there are several signs pointing to its continued persistence, which will have encouraged MPC members to make the 50bps move today. Headline inflation fell for the second month in December to a level of 10.5% YoY which was in line with market expectations, but the core measure (excluding food and energy) proved slightly stickier than expected at 6.3%. There is still tightness in the labour market, with survey measures of recruitment indicating continued difficulty in hiring. Wage growth running at 7.2% in the 3 months to November remains far above a level consistent with the Bank’s 2% CPI inflation target. In today’s statement, the Bank said, “If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.”, omitting the word ‘forcefully’ from a similar sentence in the previous statement.

Prior to the meeting, expectations for future increases in rates were modest – perhaps another cumulative 50bps before peaking at the June or August meetings. This represents a considerable downgrade on what markets expected in November, which was for rates to reach around 5.25%, and caused Governor Andrew Bailey to suggest they were too high. Market expectations now seem fairly in-line with the Bank.

Bottom Line

The UK economy is surprising on the upside, albeit from gloomy prior expectations. The Bank needs to weigh these prospects with the evidence that inflation in the UK continues to look stickier than in some other advanced economies. While the UK economy has little bearing on the international earners which dominate the UK equity market, it should continue to do well by virtue of its defensive sectoral exposure.

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

Alex Clare

02/02/2023

Please see the latest Brooks Macdonald Investment Bulletin received this morning (26/01/2023)

What has happened

 Yesterday’s equity session started poorly but gradually recovered over the course of the day with the US index broadly flat by the close. One of the primary drivers of the weaker market narrative earlier in the day was Microsoft’s Azure sales outlook which disappointed investors. Earnings after the closing bell last night included IBM and Tesla which both beat earnings estimates, setting US index futures up for a better day today.

 Bank of Canada

 Ahead of a busy week of central bank meetings, the Bank of Canada announced their latest policy statement. The bank raised rates by 25bps, in line with expectations but did so alongside a dovish statement. The bank said it expected ‘to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases.’ This pause in rate hikes was conditional on inflation coming under control after the bank’s 8 rate hikes in a row however with the Bank of Canada seen as a monetary policy leader this cycle it will be closely watched by other central banks.

 Preview of next week’s meetings

 On Wednesday next week we have the Federal Reserve where a 25bp rate rise is fully priced into the market’s expectations. The Fed, distinct to the Bank of England for example, operate a range for its interest rate policy, currently the lower bound is 4.25% and the upper bound 4.5%. After next week, the Fed is expected to hike again in March before taking a pause with the upper bound of 5%. The Bank of England is also expected to raise rates on Thursday next week but the bank is viewed as behind the curve by financial markets and therefore a large 50bp hike is the bond market’s base case. The UK ‘terminal rate’ is expected to reach between 4.25% and 4.5% by the summer. Lastly the pricing of ECB policy has been quite volatile as investors try to reconcile better economic data, falling inflation and lower energy prices with a hawkish central bank. The market has fully priced in a 50bp hike next week and a good chance of another in March however the terminal rate for the ECB, expected to be reached over the summer, is expected to be a mere 3.25%.

 What does Brooks Macdonald think

 The ECB is expected to maintain its hawkish narrative for the foreseeable future, in part as the ECB has been behind the US and UK in raising interest rates and therefore is further from ‘restrictive’ territory. One of the major risks in markets however is the number of rate cuts priced into the US market by the end of this year. The market expects two or three 25bp cuts before the end of 2023, and given the Fed’s hawkish narrative at recent meetings, there is a strong disconnect between the bond market and the Fed at this juncture.

Bloomberg as at 26/01/2023. TR denotes Net Total Return

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

Alex Clare

26^th January 2023

Please see below, a ‘Monday Digest’ from Tatton Investment Management discussing the key economic news from the past week. Received this morning – 23/01/2023

Overview: Slowing growth throws markets into a bind

The upbeat start to the year, where markets kept rising – because bad economic news was actually good news in terms of lessening concerns over future interest rate rises – had to end sooner or later. Sure enough, over the course of last week, various economic data releases in the US painted a clearer picture of a slowing economy, from declining Christmas retail sales to industrial production. Even though this pushed long-term bond yields down further, and had longer term inflation expectations decline to a very benign 2%, this time markets took the bad news negatively, giving back some of the gains of the previous week.

This tells us that markets may well have run out of positive momentum, and that it will be a tough ask for US markets to push higher on the back of receding rate rise fears only. In Europe and even the UK on the other hand, where macroeconomic data continues to come out ‘not as bad as feared’ but with price inflation also receding, stock markets had a much better week, even if the FTSE100 has still not managed to close above its all-time high it has neared over the past two weeks.  

There was better news globally. China said it was past the peak in Covid-related hospitalisations. Hong Kong authorities are even telling people with asymptomatic Covid infections to return to work. Ahead of this week’s Lunar New Year celebrations, travel has picked up to near normal levels. More and more research houses are pointing towards the likelihood that China’s re-opening will deliver a similar growth surge as the western world experienced in the spring of 2021, except with even more pent-up demand and cumulative savings in the hands of consumers after three years of harshly restricted public life.

PPI pullback and the ‘new normal’ for inflation

Judging by capital market expectations, we are over the inflation hump, and price increases are now expected to trend downward in the US, UK and Europe. US Treasury yields have fallen consistently since the beginning of November and are now back to where they were in September – just before the world had a UK-inspired bond rodeo. This implies lower growth and price expectations in the years ahead, and comes on the back of a 6.5% December annual inflation reading in the US – its lowest in more than a year. Lower inflation readings are backed up by both easing supply constraints and notably weaker demand. Global demand has slowed substantially, easing public pressure on central banks to bring demand-driven inflation down.

Of particular note then, is the fall in producer price inflation (PPI). While it mirrors and starts with commodity price changes, it also more tightly reflects businesses’ waning pricing power across the whole value chain. It is therefore seen as a good indicator of the supply-demand balance. PPI has been trending consistently down in most regions – particularly Europe – for the last few months. The one exception is China which, after years of repeated lockdowns, finds itself only at the very beginning of the same recovery cycle that pushed up prices in other regions since the spring of 2021. All the same, Chinese PPI is starting from a much weaker position, deeply negative.

Central banks still seem committed to tightening policy, in spite of a weakening economy. Nevertheless, these PPI figures point to a very different scenario. Far from entrenched inflation, it looks like the US backdrop became disinflationary around September, and has stayed that way into the new year. In that time, global demand and price pressures have eased greatly. Energy prices – particularly for wholesale natural gas – have fallen substantially since November on the back of a much warmer winter than expected. Even Bank of England governor Andrew Bailey – a committed hawk in the global inflation fight – has admitted this makes the job much easier. He is now optimistic about an “easier path” out of inflation pressures. 

While capital markets are buying into this optimism, not everyone is convinced. There is an emerging view that the old regime of 2% average inflation is gone, and will be replaced by an average much closer to 4-5% over the long-term. This is reportedly a view shared by many of the movers and shakers at the World Economic Forum in Davos, and it backs up commentary we are seeing quite widely in the financial media. The thought is that, due to structural changes in the global economy, central banks will no longer feasibly be able to target 2% inflation and will have to adjust their targets higher. This will mean structurally higher interest rates too – a far cry from what we saw in the period between the global financial crisis and the pandemic. 

We can only point out that moving to a regime of 4% annual inflation is not a simple matter. Inflation disproportionately affects lower income earners by destroying their purchasing power. To counteract this, the economy has to give disproportionate wage increases to the less well-off, or else inequality grows dramatically, with potentially disastrous political consequences. Investors have to understand how a 4-5% annual inflation regime has the potential to eat into available capital returns – unless compensating productivity increases plug the hole. Davos attendees should be careful what they wish for.

Monetary easing in Japan: endgame or dawn of a new era?

Japan’s bond market is faltering. Bank of Japan (BoJ) Governor Haruhiko Kuroda, nearly at the end of his ten-year tenure, is committed to controlling the yield curve in his aim to stimulate the economy. But bond traders doubt he or his successor will be able to. The result has been selling pressure on Japanese government bonds (JGBs), and the BoJ having to hoover up those sales to maintain its target. The fallout has affected currency and equity markets, creating a notable tightening of Japan’s financial conditions.

The BoJ’s monetary policy approach of yield curve control – began by Kuroda in 2016 – is unlike any other central bank. Instead of committing to buying a fixed number of government bonds, the BoJ sets a yield target (currently at 0%) and will buy any amount of bonds necessary to meet it, with some fluctuation around the target. Yield curve control (YCC) has always had its doubters, but the policy worked surprisingly well for years, due to markets’ belief about the credibility of the BoJ’s promise and the stability of Japan’s economy. But cracks appeared last year, as sharply higher interest rates in the US made JGBs less attractive. Investors sold yen assets – many back to the BoJ – putting massive downward pressure on the currency. The surge in global prices meant inflation had finally come to Japan too, leading to speculation that YCC would be abandoned. Bond traders thought this was all but confirmed in December, when the BoJ suddenly announced it would tolerate a 0.5% rise in ten-year JGB yields. 

However, last week Kuroda used his penultimate meeting in charge to quash those expectations. No changes were announced, keeping interest rates at -0.1% and the ten-year yield target at 0%. The decision “sets the BoJ up for a protracted battle with the market,” according to a Tokyo-based JPMorgan strategist. The BoJ’s longest-serving governor is sticking to his guns, but his successor might struggle to show the same resolve. Traders expect great selling pressure and a difficult decision ahead. Whoever takes over from Kuroda will undoubtedly share his dovish philosophy, wanting to keep financial conditions easy and maintain the YCC if possible. But markets will no doubt test the BoJ’s resolve with renewed selling pressure on JGBs. The BoJ already owns more than half of the outstanding JGBs – an unprecedented footprint for any central bank. The closer that percentage share gets to a hundred, the more questions will be asked about the viability of YCC.

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

Alex Kitteringham

23^rd January 2023