Over the past fortnight we have seen the major stock and bond markets weaken, on the expectation that developed economies’ central banks will raise rates higher, and for longer, than previously expected. This is to squeeze out stubborn core inflation.
We can expect this theme to persist over the coming months, until it becomes clear that output gaps are emerging in the U.S. and European economies.
For all the talk by American and European governments of supporting their central banks’ fight on inflation, none are willing to raise taxes on a temporary basis in order to weaken demand, or make significant cuts in public spending. The IMF, and the Bank for International Settlements (BIS), have become particularly shrill on this point in recent months, to little effect. The fight against inflation is being left to the central banks.
Last week’s data rather proves the point
Last Friday’s non-farm payroll data will have comforted the Fed, with new job creation at 209,000 (below the 225,000-consensus estimate). *
However, this followed strong private sector hiring data earlier in the week, that underlined the ongoing strength of the labour market, and despite 18 months of interest rate hikes. Tellingly, Friday’s labour market data also included monthly hourly pay growth, which was up 0.4% month on month, ahead of the 0.3% consensus estimate.
The June Fed minutes, ** released last week, showed that the central bank had intended to raise interest rates again even, as it paused them last month. Across the Atlantic, the governor of the Bank of England, Andrew Bailey, last week reiterated the need to bring down inflation or risk still higher rates in the future. Similar messages come from the ECB on a regular basis.
Hence the rise in two-year government bond yields over the last fortnight and the falls on major stock markets. The U.S. two-year Treasury yield is back to levels last seen in March (4.92%), while in the UK the two-year gilt yield (5.41%) is now higher than it was in the confused days of Liz Truss’s premiership last autumn.
Core inflation now dominates CPI numbers
An illustration of the inflation problem can be seen in current U.S. inflation data. This Wednesday, we will see June headline and core CPI numbers released.
Headline inflation is expected to come in at around 3.1%, down from 4.0% in May. This reflects the fall, on a year-on-year basis, of food and energy prices. But inflation in goods and services, the two groups that dominate core inflation, remains stubborn. Economists are expecting core inflation in June to come in at 5% year on year, just below May’s 5.3 percent.
We see a similar story throughout the developed economies, in which it is domestic demand that is now driving inflation, with food and energy prices now exerting a disinflationary force. Central banks want to create what they call an output gap and what we might call a rise in unemployment, in order to reduce wage growth and demand in the economy for goods and services.
Interestingly, long dated bond yields have also risen as the prospect of a prolonged core inflation problem becomes more widely accepted. The U.S. 10-year yield now stands at 4.09%. *** This has helped to slightly reduce the inversion in the U.S. Treasury market between the two- and ten-year yield, the gap is ‘just’ -0.88%. A negative yield has, in the past, often preceded a recession in the U.S. This remains one of the largest gaps recorded in post-war U.S. history.
On developed stock markets, cyclicals and real estate have been amongst the most affected sectors, a classic market signal that the next economic upturn is being postponed. Tech stocks, which so far this year appeared to have defied the ratcheting up of interest rates, have also suffered as higher long-term costs of capital become factored into valuation models.
What does this mean for investors?
Perhaps more months of adjustment to a higher interest rate regime, which means pricing in a higher likelihood of recession in the U.S. and Europe and reducing corporate earnings forecasts for the coming quarters.
From a portfolio point of view, traditional inflation hedges continue to look attractive. These might include commodities, defensive stocks (e.g., consumer Staples and utilities). Yields on short dated U.S. treasurers are no longer losing investors’ money in real terms and are of increasing interest to multi asset investors given the poor bank rates on offer.
Investors should remain invested in a multi asset portfolio that offers exposure to a variety of asset classes. Financial history shows this is the best way of maximizing returns, relative to the amount of risk taken.
What is sterling telling us?
Finally, we have mentioned previously the UK’s particularly stubborn inflation problem. This reflects a decade of weak private and public sector investment, which limits productivity improvements and an unusually high number of absent workers that has led to acute labour shortages and so to strong pay growth. May’s CPI numbers, that showed a rise in core inflation to 6.5%, confirmed this point.
As a result, market consensus is now for Bank of England interest rates to rise from 5% to 6.5% in the current cycle.
But sterling has not rallied as the forecasts for UK rates start to considerably exceed those of the U.S. and elsewhere. At $1.28, the pound is where it was six weeks ago. Is there a period of strengthening ahead, as global currency investors are attracted into relatively high yielding gilts?
Or is the current account deficit weighing on the currency- i.e., the gap between what the UK exports and imports, added to the net income on investment flows in and out of the UK.
This Issue used to haunt sterling in the post-war decades. An expected balance of payment deficit of 3% of GDP this year, which is being driven by strong imports of goods, would normally be associated with a period of rapid economic growth. And yet the consensus forecast is for just 0.4 year on year GDP growth (i.e., very weak demand growth)!
Could it be that the output potential of the UK economy is now so limited that it cannot meet even very modest demand growth from domestic resources? This brings us back to the points mentioned above, about low investment spending and a shrunk labour market.
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