Navigating through the fog
There are times when the economic environment is wonderfully clear, other occasions when investors and policy makers are looking at a fog, taking difficult decisions against the backdrop of blurry economic statistics. This explains why some central bankers are pausing to reassess the state of monetary policy, whilst others are pressing ahead at full speed.
The latest survey of the state of the labour market in the USA was not very transparent. Some statistics suggested a tight market, the shock headline ‘shock’ was a rise of 339,000 in new jobs, on top of upward revisions to previous months – apparently, the US economy is booming! Other aspects suggested an economy slowing fast, as the unemployment rate rose, to its highest level since October, whilst hours worked declined, to the lowest level since April 2020. After assessing such news, it was not a great surprise to hear from Fed Governor Patrick Harker that “It’s time to at least hit the stop button for one meeting and see how it goes”.
The problem facing the Federal Reserve and indeed other policy makers is that parts of the economy are in recession – housing is generally weak, and manufacturing sector activity has been well below the boom-bust dividing line since November. This partly reflects changes in consumer spending patterns since the end of the pandemic. Much more is being spent on experiences & leisure, and much less on goods. US car sales, for example, are still well below their 2016-19 levels. These trends are seen in most countries; although the global purchasing manager index, a widely examined survey, was 54 in May, its highest level for 18 months, this masked continued strength in services and considerable weakness in the manufacturing components. Even though average earnings growth did decelerate in the latest US employment report, much of that will reflect the different pace of hiring across higher or lower wage sectors.
Even if the situation looks murky in some countries, elsewhere the picture is clearer. Bond markets were surprised by the news this week that central banks in Australia and Canada unexpectedly raised interest rates. The Bank of Canada explained its decision by referring to strong consumer spending, a rebound in demand for services, and a tight labour market, all showing demand has been more persistent than expected. “Concerns have increased that CPI inflation could get stuck materially above the 2% target” The Reserve Bank of Australia made very similar comments, concerned that “the return of inflation to target requires a more sustainable balance between aggregate demand and supply”.
The ECB appears determined to drive fast through the fog of European economic data. On the one hand, revised GDP figures suggest that activity across the Eurozone experienced a mild decline in the last two quarters. Looking ahead, German industrial production is weak, and factory orders have shown 14 consecutive months of annual declines. The outlook is not good in the light of trade data suggesting further weakness in the all-important Chinese economy. On the other hand, the Euro area unemployment rate fell from 6.6% to 6.5% in April, which again reflects buoyant service and consumer spending. Many businesses are still reporting a shortage of labour. The ECB pays close attention to its models. As Christine Lagarde said, “we have made clear that we still have ground to cover to bring interest rates to sufficiently restrictive levels”. Joachim Nagel agreed “From today’s perspective, several more rate hikes are still necessary. For me, it’s not certain that we will reach the interest rate peak in the summer. Underlying pricing pressures are also far too high and so far show little sign of abating”.
The Monetary Policy Committee remains ‘data dependent’ but on balance it will be pleased to see various signs that higher interest rates are working their way through the UK economy. Data from building societies, banks and housebuilders shows a definite slowdown in housing market activity, such as mortgage approvals back at 2020 levels. Indeed on balance the household sector is repaying mortgage debt. The British Retail Consortium survey of retail sales and Barclaycard credit card data show declining consumer spending once inflation is taken into account. High food prices are forcing households to switch their spending towards food retailers and away from other shops. Lastly, a KPMG/REC survey cited a slowdown in hiring. Against that backdrop, however, the OECD raised its forecast for UK economic growth this year, avoiding recession. Consumer spending should be boosted by lower food prices; the UN reported that wholesale global food prices fell again in May and were over 20% lower than a year ago. Much for the MPC to mull over at its next meeting.
Central bankers may not see through the murky environment any better than the markets do, but they appear to be winning the war of words with their message to “take rates up and leave them there until the economic outlook is much clearer”. Investors are well aware that the Fed looks set to pause in June, but against the backdrop of recent moves by Canada and Australia, further signs of action by the ECB and MPC over the summer, and in particular the continued strength of core inflation in most countries, it is little surprise that over the past month bond yields have moved up by 0.1-0.25% in Europe, by 0.25-0.5% in the USA and by 0.5-0.75% in the UK. Expectations by some investors of interest rate cuts as soon as the autumn require the fog to clear across a wide array of economic data.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.53 3.87 3.739
UK 4.55 4.26 4.29
Germany 2.95 2.43 2.41
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