Please see below, a ‘Monday Digest’ from Tatton Investment Management discussing the key economic news from the past week. Received this morning – 30/01/2023:
Overview: Goldilocks makes a reappearance
Recent macroeconomic data releases report declining rates of inflation and underwhelming (but nevertheless still positive) economic growth across the western world. Perhaps unsurprisingly then, the term ‘Goldilocks’ (not too hot, not too cold) returned to the market narrative. There are rate rises expected from the major central banks this week, but on the back of the ‘Goldilocks’ data picture, markets now price in for the US Federal Reserve (Fed), to further reduce the size of this rate rise from 0.5% to just 0.25% – and only for a further one or two more hikes to follow before then reversing quite quickly to rate cuts again later in the year. The idea of central banks managing to induce a soft-landing – reversing inflation without causing a recession – is gaining momentum among the market commentariat.
At Tatton, we see the current environment more as a temporary market truce, or period of ‘wait-and-see’ as the economic reality unfolds and evidence tilts the balance of arguments in one direction or the other. In this respect, central bank actions and their (just as important) accompanying comments will be very closely observed as will further inflation figures and Q4 2022 company earnings trends.
As has been the case over the past few months, the UK is somewhat trailing economic trends elsewhere, and consumers and private investors can be excused for not sharing in the more upbeat sentiment. Last week’s news that UK car production had declined to the same levels as the 1950s does not indicate economic vibrance. However, the more positive economic picture emerging in some of the most important markets for UK multinational companies, bodes well for the still comparatively cheap UK large cap stocks. The UK government clearly has a substantial to‑do‑list in its in-tray for those trading opportunities to materialise. So, the next stage of post-Brexit trade normalisation will be a key area to watch here, beyond the inflation, labour market and company earnings briefings elsewhere.
US debt ceiling showdown looms (again)
The US government’s total outstanding debt has once again hit its ceiling. This legal limit on how much the US Treasury can borrow is updated periodically by Congress, and was most recently set at $31.4 trillion in December 2021. Of course, raising the debt ceiling should be a no-brainer, considering it is just a procedural financial constraint that does not affect already agreed spending commitments. But since the Obama era the Republican party has periodically used the debt ceiling to get all manner of fiscal concessions from the White House. Most recent showdowns during the Biden years have been resolved more quickly though, as Congress seemed less concerned about spending during the pandemic. Unfortunately, this time the fight could be more ferocious than at any point in the last decade.
First, the unofficial Covid moratorium on budget balancing is long gone. Second, over the years, politicians and investors have become complacent that the other side of the equation will work out in the end – meaning risks are likely underappreciated. Finally, and perhaps most worryingly, the Republican party is now at the mercy of its most radical members, as the recent protracted election of new House of Representatives speaker Kevin McCarthy demonstrated. Among the concessions McCarthy pledged Republican members to win their vote included a commitment to not raise the debt ceiling without sweeping budget cuts.
A compromise still seems inevitable, but these background factors mean it is likely to skew fiscally hawkish. We are still cautious though. We saw how damaging short-term disruption can be with the UK’s own bond yield blowout last October. The threat of default – even a brief, accidental one – with yields shooting up violently will loom large over the US bond market, and could spook investors’ fragile confidence. With such a huge amount of debt outstanding, even a short-term rise in yields could adversely affect the US fiscal position for years to come. Perhaps the most worrying part is that all of this is avoidable. Both sides know this, and yet neither seem particularly eager to avoid it. We suspect that the debt ceiling debate will become mainstream in the months ahead, and could well make fiscal policy a defining issue for the next presidential election.
LatAm common currency far from a Sur thing
According to reports from Buenos Aires, South America’s two largest countries are set to announce preparations for a single common currency, which would become the world’s second-largest currency union after the Eurozone. Brazil and Argentina want a common currency to start as a bilateral agreement between them, but with the aim of expanding it across the entire region. Both are main members of Mercosur (translation: ‘Common Market of the South’), a South American trade bloc that includes Uruguay and Paraguay as full members, with seven more associate nations. There would be a lot to gain from such an initiative. Trade between the two countries is huge and still growing – with 21% more direct trade last year than in 2021. Moreover, Latin American economies are expected to grow rapidly over the next few decades.
However, Brazilian politicians and its public would likely baulk at the idea of tying their nation’s finances to the more profligate Argentina. Argentina has defaulted on its national debt more times than most care to remember, and has effectively been cut off from international debt markets since the last default in 2020. It still owes $40 billion to the International Monetary Fund (IMF), while Brazil is a net creditor to the global financial system. Even so, there are certainly benefits for the two countries. Bilateral trade at the moment depends heavily on US dollar financing, meaning traders are often at the whim of US economic policy. Rectifying that would increase cross-border efficiencies. It is also no surprise that this proposal is favoured more by the countries’ left-wing politicians, despite its apparent focus on free trade. Freedom from US interference or economic power has long been a goal of the Latin American left. That is what Brazil-Argentina integration points to.
And even if no one else gets on board with a common currency or accounting unit, it is very likely that Latin American leaders will be swayed by the idea of stronger regional ties and less reliance on the US. Such integration often naturally leads to economic convergence – perhaps making the common currency idea less senseless in the distant future. It is worth remembering, after all, the road that led to the euro. When the Treaty of Paris was first being discussed after the Second World War, the notion of a common European currency would no doubt have seemed equally fanciful.
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Carl Mitchell – Dip PFS
Independent Financial Adviser
30/01/2023