Focus on the fundamentals
Financial markets were relieved by some good news this week. American politicians pulled back from transforming the debt ceiling saga into a global financial crisis. Investors can turn their attention to the underlying economic fundamentals, which on balance suggest that while central banks will act again over the summer, some of the more alarmist predictions about aggressive actions can be rolled back.
An unpleasant mixture of growth and inflation certainly remains a concern in many countries, generally because core inflation is being sustained by relatively strong economic activity. The USA is a prime example. The Chicago Fed’s National Activity Index, a useful measure of economic momentum, remains in positive territory. This reflects the continued buoyancy of consumer spending, still growing slightly above its long term trend. The annual rate of inflation as measured by one favourite Fed indicator (entitled the core personal consumer expenditure deflator) picked up to 4.7% in April, while a measure of core inflation from Dallas Fed (its trimmed mean) reached 4.8%, the highest reading seen since November 1982. These are hardly figures which the Fed can comfortably ignore. Core inflation largely reflects wages and the state of the labour market, and here this was better news. April’s employment report will be examined with considerable interest. However, early indications, from consumer confidence and jobs openings data, suggest that demand for new workers is easing at a moderate pace.
The mix of data encouraged a majority of Fed officials to agree that the Fed can pause in June and assess the state of play. Loretta Mester caught the headlines with her view that with the removal of the debt ceiling as an issue, then there was little reason not to tighten policy another notch. However, a succession of other speakers pointed towards a pause. “Skipping a rate hike at a coming meeting would allow the Federal Open Market Committee to see more data before making decisions about the extent of additional policy firming” said Philip Jefferson. A new factor which the Fed may have to take into account is pressure on regional banks’ share prices after reports of further weakness in commercial real estate. The Fed will also look carefully at the details of the fiscal package surrounding the debt ceiling agreement. Early indications are that the pull back on government spending will act as a small headwind to growth in coming years.
In the UK, markets have scaled back some of the aggressive monetary tightening priced in for this year, in effect taking one rate increase out of their calculations. However, the need to act remains very clear. Surveys suggest that retail sales appear to have bottomed out, supported as ever by high levels of employment. Whilst food inflation has decelerated for the first time in almost two years, according to the British Retail Consortium, prices still rose by 15.4% year-on-year, versus 15.7% in April.
Economists at central banks will also pay attention to words of warning about future energy prices. This week the energy ministers of Qatar and Saudi Arabia warned the “worst is yet to come” for Europe’s oil and gas shortages. Last winter, the weather was milder than usual and the global economy was restrained by weakness in China. As one Minister said “if the economy starts churning back up in 2024 and you have just a regular winter, I think the worst is yet to come”.
Europe is marching to a slightly different tune, as a gap is opening between the rhetoric being heard from the ECB and the state of the economy. In the view of Klaas Knot, more tightening is required: “the two hikes in June and July are fully priced in and our inflation outlook is already conditional on those…. so we should deliver on them…. from September on, I am open-minded…. if we reach the peak in rates, at some not too distant point, we will probably have to stay there for a significant period….market pricing of rate cuts is overly optimistic”.
Such views are despite another survey signalling more weakness in European manufacturing, not helped by further signs of a slowdown in the all-important Chinese export market. Eurozone money supply growth has fallen back to its slowest levels since 2014. At the same time, Euro area consumer price inflation for May is definitely rolling over, down to 6.1% in the year to April. The ECB also admits that parts of the Eurozone such as the housing market face economic ‘disorder’ due to the sharpest monetary-tightening cycle in its history. All this helps explain why the markets think the ECB may pause after July.
One economic statistic sums up the dilemma facing central banks this summer. European economic growth has been below trend, the central bank has undertaken the sharpest monetary tightening in its history, yet core inflation across the Eurozone in the year to April was still as high as 5.3%. The ECB, the FOMC and the MPC are all searching for signs that interest rates can reach a peak, but they also know that it takes time for monetary policy to affect the underlying economic fundamentals and convince them that inflationary pressures are truly returning to target.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.35 3.72 3.62
UK 4.29 4.06 4.12
Germany 2.74 2.24 2.25
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making