- Weak European PMI data and energy crisis concerns elevate recession fears
- Jerome Powell’s testimony points to exogenous factors as risk of a ‘hard landing’ grows
- Equity markets bounce following three weekly declines; bond yields rally on growth and inflation concerns
- Next week: Growth and inflation data to take centre stage as G7 and NATO summits commence
Weak European PMI data and energy crisis concerns elevate recession fears
Weak European data released this week only served to ramp up recession fears. Preliminary PMI data for June undershot expectations across the board, as economic activity, which has been resilient until now, showed signs of faltering. The most notable miss was the services PMI, which came in at 52.8 (vs 55.5 expected and 56.1 prior), while manufacturing came in at 52 (vs 53.8 expected and 54.6 prior). Hence, the composite PMI fell to a 16-month low of 51.9, edging closer to contractionary territory (<50). The tailwind of pent-up demand and savings is now being offset by the current price squeeze to consumers and businesses as well as uncertainty around the current economic conditions. This was also reflected in the Eurozone consumer confidence indicator which fell to -23.6, lower than April 2020 (-22.7). In fact, this is its lowest level since February 2013.
Additionally, on Thursday, Germany’s economy minister Robert Habeck implied there were serious concerns over a potential cut-off in gas supply from Russia’s Nord Stream 1 pipeline. He made comparisons of this event to that of the role of Lehman Brothers in the financial crisis. Germany have raised their gas risk level and are now only one step below the final “emergency” stage. This stage, which involves state-controlled distribution, would see supply to industry diverted to households and critical institutions.
Jerome Powell’s testimony points to exogenous factors as risk of a hard landing grows
The other major news story during the week was Federal Reserve (Fed) Chair Jerome Powell’s testimony to the Senate banking committee. His comments tilted towards hawkish as he warned of the possibility of recession, with a number of exogenous factors out of the control of the Fed. Most notable are soaring commodity prices which stem from Russia’s invasion of Ukraine, and continued supply chain disruptions caused by China’s strict Covid-19 policy. Central banks and markets alike have become increasingly aware that a hard landing will be difficult to avoid, in what has been dubbed a fire (high inflation) and ice (slowing growth) macroeconomic environment. Commodity prices, particularly oil, have taken a step back from the recent highs due to their correlation with slowing growth. We are monitoring the growth story closely for further signs of deterioration; however, we remain above our long-term average weighting as we expect the elevated levels of inflation and further potential energy shocks to push commodities higher.
Equity markets bounce following three weekly declines; bond yields rally on growth and inflation concerns
Equity markets have seen a bounce this week following a number of equity indices entering bear-market territory last week. The S&P 500 and NASDAQ are both on track for their first weekly gains in a month, having closed Thursday +3.29% and +3.83% respectively. The FTSE 100 and STOXX 600 look likely to do the same, although are lagging slightly with STOXX 600 in particular being brought down by German energy fears. The DAX Index therefore is likely to end in negative territory for the fourth consecutive week having fallen by -1.76% on Thursday alone.
Bond yields fell over the week, with the 10-year Treasury yield falling back to approximately 3.1%, while Eurozone bond yields declined towards the end of the week given higher risk aversion and investors becoming increasingly concerned about slowing growth as inflation rises. ECB President Christine Lagarde warned of the growing possibility of a severe correction in Europe’s financial markets. While the ECB has all but committed to tightening its monetary policy from July, Lagarde said the “risks to financial stability have perceptibly increased”. The German bund yield subsequently fell the most in a day (by over 20bp on Thursday) in more than 10 years and fell nearly 30bp over the week to around 1.45%.
Next week: Activity and inflation data to take centre stage; G7 and NATO summits commence
Next week will be fairly data centric as a number of key measures are due to be released. In the US, the focus will be on confidence and activity indicators with durable goods, inventories, consumer confidence, and personal income and spending all preceding Friday’s ISM data. Meanwhile in Europe the centre of attention will be inflation with the Eurozone aggregate released on Friday. The current market consensus is for this figure to hit 8.3%, surpassing May’s 8.1% rise albeit at a slower month on month pace. China’s industrial data and PMI release will also be of interest as investors look to gauge the rebound as the country slowly emerges from lockdowns. Finally, in geopolitical news the G7 Summit is starting on Sunday before the NATO Summit kicks off on Wednesday.
- US Federal Reserve hikes rates more than expected; housing market softening given rate hikes, equities fall
- Bank of England hikes rates more gradually, Bank of Japan retains an easier monetary policy stance
- European Central Bank vows to introduce tools to fight “fragmentation”, which may clear path for higher rates
- Next week: Central bank speeches could clarify thinking, global PMIs and UK inflation to provide economic update
US Federal Reserve hikes rates more than expected, housing market softening given rate hikes, equities fall
In the wake of last week’s higher-than-expected inflation print in the US, speculation grew that a 75bp hike was being considered by the US Federal Reserve (Fed). This quickly became market consensus after a Wall Street Journal article on Monday evening that sparked a sharp sell-off in government bonds. The Fed delivered upon this market view, raising rates by 75bp to 1.75% and its accompanying statement highlighted the challenges it (and other central banks) face, in that a hard landing will become harder to avoid given the policy tightening they view as necessary to tame inflation.
Although Fed Chair Powell stated that he didn’t expect “these [75bp hike] moves to be common”, he noted that they would need supply-side response to help avoid a hard landing. These rate hikes are expected to help slow the economy, reflected in the revision to the Fed’s expectations that unemployment is expected to rise to 4.1% by the end of 2024. Most directly the US housing market is showing some signs that recent rate hikes are dampening economic activity. Both housing starts and building permits were weaker than expected and mortgage rates (as illustrated by the Freddie Mac 30-year mortgage rate) rose from 5.23% to 5.78%, the highest level since November 2008.
In terms of market impact there were sharp revisions to government bond yields over the period. Government bond yields rose sharply as expectations grew of a 75bp hike before rallying back; 5-year US Treasury yields rose from 3.25% to 3.60% early in the week, before rallying back towards 3.30% after the Fed had delivered its rate hike. The US yield curve, typically seen as a leading indicator of an economic recession, briefly inverted as 2-year yields surged to a 15-year high.
Risk assets also came under significant pressure, with a number of equity markets passing officially into bear-market territory. Given that we haven’t seen a decline in profitability yet, equity markets remain vulnerable to further weakness and a cautious outlook remains warranted in our view.
Bank of England hikes rates more gradually, with Bank of Japan retaining an easier monetary policy stance
The Bank of England (BOE) maintained a more dovish stance than many of its peers by only hiking rates by 25bp to 1.25%, albeit the highest level for 13 years. The BOE appears more concerned about the growth impact of tightening policy too quickly compared to its peers, although it did recognise that it may need to take more “forceful” action if inflation is more persistent that it currently forecasts. The Monetary Policy Committee was again split, with three of the nine members voting for a larger 50bp increase in policy rates. Economic growth continues to weaken in the UK, with GDP contracting by 0.3% in May, worse than market expectations. The recently announced fiscal response is not expected to materially change this dynamic, with growth to be boosted by 0.3% over the next 12 months.
The Bank of Japan, by contrast, retained its easy monetary policy stance, noting that although its latest inflation print was above its 2% target, it remains low by international standards. However, they also had to purchase unprecedented levels of Japanese government bonds to defend its prescribed yield curve control targets. The Japanese yen continues to weaken in face of this widening interest rate differentials and is now at 24-year lows, an indicator the Bank of Japan noted it must “pay due attention” to over the coming weeks.
European Central Bank vows to introduce tools to fight “fragmentation” which could clear the path for higher rates
Whilst the European Central Bank (ECB) did not hike rates this week, it did call an emergency meeting at which it pledged to fight “fragmentation risks”; a proxy for trying to ensure that tightening policy does not lead to undue financing pressures upon peripheral countries such as Italy. The ECB reiterated it would flexibly reinvest redemptions from its asset purchase programme (PEPP) and would accelerate the pace of its “anti-fragmentation” tool. These moves highlight that government bonds remain vulnerable to persistent inflation leading to faster rate hikes at the same time that equity markets could come under pressure from falling profitability.
Next week: Central bank speeches could clarify thinking, global PMIs and UK inflation to provide economic update
Next week will see a number of important speeches by central bankers, with Fed Chair Powell testifying in front of the Senate and House Committees, which may provide investors with an update as to their thinking behind the more aggressive rate hike and an opportunity for the Fed to guide market expectations. A number of members of the Bank of England and the European Central Bank are also expected to speak and potentially clarify their view of the balance they are trying to strike between raising rates to curb inflation and the negative impact this would have upon weakening growth expectations. The release of the flash PMIs on Thursday will provide investors with a timely indication of the current growth expectations across the US, Europe and Japan. We will also receive an update on UK CPI, consumer confidence (Europe and UK) as well as the outcome of the second round of elections in France that may lead to President Macron losing his parliamentary majority.
- European Central Bank keeps interest rates unchanged but provides a hawkish view on future policy decisions
- US CPI exceeds expectations leading the market to price in more aggressive monetary policy tightening
- The World Bank warns of stagflation in the global economy
- Next week: Federal Reserve and Bank of England expect to hike; important growth data from China
European Central Bank keeps rates unchanged and provides a hawkish view on future policy decisions
The investment backdrop remains characterised by tightening financial conditions, uncomfortably high inflation, and mixed evidence as to whether growth was moderating sufficiently to quell inflationary pressures. Both the economic outlook and the market environment appears heavily dependent on the path of inflation as central banks prioritise the need to avoid a self-reinforcing wage price spiral.
With this in mind, attention turned to the European Central Bank (ECB) this week as they delivered their latest policy decision and provided guidance on their future plans. The bank left its main refinancing and deposit rates unchanged in June, at 0 and -0.5%, respectively, which was in line with the market consensus. More focal was future guidance, where there was confirmation that net asset purchases would conclude at the end of this month, and the necessary conditions to start raising interest rates had been met. The ECB confirmed its intention to deliver the first 0.25% increase in the July meeting, and put an option of a 0.5% increase at the September meeting on the table. Overall, the statement and the subsequent press conference were hawkish, with acknowledgment of the challenges inflation brings and the need to get back to target. The market reaction was for sovereign bond yields to move higher, and the spread of peripheral European sovereign bonds vs the German bund to move wider still, reaching their largest gap for years.
US CPI exceeds expectations leading the market to price in more aggressive monetary policy tightening
The inflation challenge for central banks remains complicated by the fact that much of the inflationary pulse has been caused by supply side factors over which they have no control – specifically the impact on energy and agriculture from the Russian invasion of Ukraine and the supply chain impact of China’s zero-COVID policy and the resultant disruption caused by lockdowns and containment measures. And with the US labour market at its tightest level for many decades, the US CPI reading for May is of vital importance. This came in at 8.6% year-on-year, which was 0.3% ahead of market expectations. Looking under the surface, food inflation was up 1.2% over the month, whilst used cars ticked up to 1.8% and airfares up 13%. On the sticky side, where inflationary numbers may become more entrenched longer term, rents rose by 0.6% - the highest monthly rise since 1990.
The immediate market reaction to the above was to price in more aggressive tightening of monetary policy by the Fed, with short end rates increasing and the curve flattening. Equity markets also fell, whilst the dollar strengthened.
The World Bank warns of stagflation in the global economy
The Washington-based World Bank stated that stagflation was a growing risk as the war in Ukraine and tight supply chains were causing inflation to rise at a time when the growth outlook was deteriorating. The World Bank said that the global economy was at risk of a “protracted period of feeble growth and elevated inflation”. It cut its forecast for global growth this year to 2.9% (it had been 4.1% in January) and suggested a similar growth rate in 2023.
Next week: Federal Reserve and Bank of England expect to hike; important growth data from China
Central banks should remain pivotal to next week’s market action, with key monetary policy decisions from the Federal Reserve, the Bank of England, and the Bank of Japan. On the former, 0.5% interest rate increases have been well-communicated for each of the next two meetings, so the decision should not come as a surprise. However, the market will be interested to hear the guidance for future monetary policy, especially after another bumper CPI print for the month of May. The market expects the Bank of England to deliver a 0.25% hike, and the Bank of Japan to remain at current levels. Outside of central bank action, it will be a busy week for the US with data on consumer trends, product, and also the housing market. There will be data out of China, namely industrial production, retail sales and property investment, which will give an insight into how the recent lockdowns have affected the trajectory of global growth.