Last week we asked, ‘is the penny dropping?’ This week we can answer, ‘yes, the penny has now dropped’.
The bull investor’s argument for the last six weeks has been that there are sunny uplands ahead; that we can ignore the current environment of rising interest rates, falling corporate earnings and rich valuations (compared to the 2010-19 period).
But the bull case for stocks now looks weak. Investors appear to recognise that the Fed’s concerns over stubborn inflation, arising from a tight labour market and of a ‘bumpy road ahead’ (Jay Powell), should be taken at face value.
Market expectations for terminal Fed rates have risen from around 5% to approximately 5.3%, and expectations of rate cuts at the end of the year pulled back from two to just one.
Wall Street gave up gains made earlier in the week, leaving the S+P500 and NASDAQ broadly unchanged, while 10-year Treasury yields rose to over 3.8% for the first time since early January. Investors appear to accept that we have further to climb to reach those sunny uplands than they had expected.
The Hang Seng and Nikkei 225 fell slightly over the week, but European stocks fared better. The FTSE100 passed the 8,000 mark for the first time on Thursday, the STOXX 50 index of leading eurozone companies was up 1.5%. The outlook for growth in Europe continued to improve as European gas prices fell to an 18-month low (and are down 85% from their August high), while on Friday, strong UK retail sales data suggests the recession forecasted for this year may not be as severe as thought.
Last week’s U.S. data helps explain why the penny has dropped.
Even before last week’s data releases, the U.S. economy looked like it was in much better shape than as recently as late December. The labour market remains very tight, and wage growth and inflation are coming down – but at a slower pace than was expected.
Last week CPI inflation in January came in at 6.4% year-on-year, a lower fall from December than had been expected. Worryingly, core inflation -which is steadily growing as a proportion of CPI inflation- was stuck at 0.4% on a month-on-month basis. Producer prices rose 6% year-on-year, stronger than expected. Finally, January retail sales came in at 3% over December’s figure, well above estimates of 1.8%, and suggesting little pulling back of demand by U.S. consumers in the face of inflation and higher interest rates.
The debt ceiling
The Republicans are refusing to vote through an extension of the $31.4 trillion Federal government borrowing limit. The Congressional Budget Office, last week suggested that the government will run out of cash sometime during the period July to September if the limit is not raised.
This is political theatre. For the Republicans, the principal of small government is apparently at stake (unless the White House is occupied by a Republican, then deficit increases are uncontroversial). For the Democrats, it is an opportunity to demonstrate Republican hostility to those who depend on Federal paychecks and welfare programs such as Medicare.
Meanwhile the financial architecture of the U.S., if not the world, is at risk if coupons on Treasuries and capital repayments are not made on time.
One proposed solution is that the Treasury mint a $1 trillion coin, which it lodges with the Fed. The Fed then credits the Treasury’s account with $1 trillion, which it can use as it wishes. A variation of this is the Treasury sells $1 trillion of coins, but in smaller denomination coins (perhaps $50 million) to institutions, probably at a discount to face value and in exchange for cash.
There don’t appear to be any theoretical objections to this form of money creation.
Arguably, selling the coin to the Fed is a variation of quantitative easing, which saw the Fed create approx. $5 trillion to help the economy cope with the pandemic. But it is a variation that hasn’t been tried on this scale before, and it could set a precedent whereby the Federal government routinely makes its own money. The idea un-nerves many economists – including the Treasury itself.
Republican Senate minority leader, Mitch McConnell, is conscious of the electoral dangers posed by his more excitable colleagues in Congress. It is not in the interest of the Republicans to prove the Democrats right when so many Republican voters are, themselves, welfare recipients.
In all likelihood, a last-minute agreement will be found, as happened during the previous debt ceiling crisis under Obama.
Helping lift the FTSE100 index to new highs last week was weakness in the pound, which fell to a six-week low of $1.198 on Friday. A weak pound flatters FTSE100 company earnings, most of whose revenue is in foreign currency.
Sterling weakness reflects lower-than-expected January inflation numbers (+10.1% year-on-year), in contrast to those of the U.S. If inflation continues to fall faster than expected, it will allow the Bank of England to end its rate hikes with one final 25bp hike later this month, taking its benchmark rate to 4.25%.
Investors should remain diversified, using a mix of asset classes to limit portfolio volatility and to maximise returns per unit of risk taken.
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- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
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