Out of the frying pan...

Market Report

• Various forces continue to buffet the global economy, with higher interest rates on the way in the UK and US next week
• Mixed messages emanating from corporate earnings season, particularly from some of the titans of the last few years
• The engine room for the world economy – the US – still looks in reassuring shape from many perspectives, even if central bankers will be looking to dim some of that pep in the months ahead

CIO view

Next week takes us back to the front line of the warming fight against inflation – both the Bank of England and the US Federal Reserve are expected to raise interest rates at their respective meetings. From there, we could begin to see some divergence between the two.

Summer approaches – you might argue that it is only appropriate the UK economic sky darkens now a little more than elsewhere. Persistent inflation continues to swamp economy-wide wages, a trend set to worsen in coming months. Some parts of the labour market have built up a useful arsenal of excess savings to mop this inflation up. However, one of several points of concern here is that the parts of society where the burden of rising energy and food costs will weigh most heavily (as a proportion of disposable income), are not the same as those where savings have piled up over the pandemic.

The UK is certainly not alone in having challenges in the path ahead. The Chinese economy is visibly sagging under the strain of the country’s worst Covid outbreak since the beginning of 2021 and the various efforts to manage a wobbling property market. Policymakers have a delicate trade-off to achieve, with the sin of a few more infrastructure boosts, hindering the transition to an ultimately more chaste economic path, less reliant on housing and infrastructure.

The difficulties facing Europe hardly need listing. Gas supply concerns flared this week as the currency of settlement threatened energy in parts of Europe. Gaming various scenarios for Euro area wide supply points to the potential for a recession in the road ahead. There are of course other even darker alleyways ahead for Europe, and the world, as war continues to rage beyond its Eastern flank.[1]

Both Omicron’s blazing trail through Chinese society and the war in Europe will have some say on incoming data on inflation. However, the concern for central bankers centres on second round effects – are we seeing inflation expectations respond? So far, as noted above, falling real wages will, in some ways, comfort central bankers that this powerfully destructive genie is not out of the bottle just yet. The reverse is obviously true for the households suffering this historic blow to their purchasing power.

Nonetheless, there are other signs that higher inflation is starting to take a stronger hold on our collective conscious. Investors in the US are among those wondering whether central banks will be willing to accept higher inflation as avoidance of (yet) another recession starts to loom larger (Figure 1). Helpfully, inflation should fall quite sharply over the summer in the US anyway. As the data lap the splurge of stimulus cheques in the second quarter of last year, we should see spot inflation tumble from current highs.

If that is the case, will we see the Federal Reserve hit the economy with what the market currently assumes will be nigh on four times 50bps rate rises by September? It seems unlikely it will be more in any case.

In the UK, the story is different as already noted. A private sector with a bit less current pep than incoming data speak of in the US, may see similarly historic interest rate hikes in the year ahead (Figure 2). The path of sterling this week nonetheless suggests that investors may be starting to question such assumptions. This is certainly part of the investment case for our continuing underweight position in sterling versus G10 currencies across our multi-asset class funds and portfolios. There may be more adjustment ahead if the UK’s near-term outlook dims to the degree feared above in the months ahead.

This week was also busy with quarterly corporate earnings announcements flooding the newswires. As we always warn, for those trying to discern the direction of the overall economy and capital markets, quarterly earnings announcements tend to provide very little signal. Some of the concerns over consumer spending in the short term described above have certainly been mirrored. The last 6 months has seen some of the corporate titans of the pandemic have their share price wings clipped, a trend that has continued into earnings season for some. Some of this fall back to earth has hinged on valuation. Ten-year US real interest rates are not yet in consistently positive territory, but the move from the beginning of the year remains pronounced, and likely unhelpful for these contemporary titans.

Some argue that this move in real interest rates provides a stiffer valuation test for certain types of companies, with certain types of cashflow. The very same that have been some of the most successful businesses of the last decade and more, a period of disinflation and broadly falling real interest rates. We would again note that the intuition here is a little stronger than the empirical evidence for this relationship. At the very least the relationship between real interest rates and varying corporate cash flow duration seems to have been part of the market’s thinking this year. Over the longer term, as noted above, this link seems a bit flakier. Interestingly enough, the twists and turns of the styles and sectors described above does appear to be a little more robustly explained by economy wide inflation.

However, alongside this debate on whether it is higher inflation-adjusted interest rates that are shifting investor perceptions on certain shapes of future cashflow piles, the swirling geopolitical economic and other forces are less controversially changing the estimated sizes too. We are emerging from a period where consumer habits have been forcibly reshaped by both the pandemic and the corresponding policy maker response. That we are potentially also seeing a more durable flip in the short-term trend in real interest rates, should serve to reinforce our humility on short-term sector, country, and style bets within your equity exposure. We are yet to find much evidence of a sufficient return for your intellectual buck in these areas. We tend to focus our efforts elsewhere in the investment value chain, with tactical asset allocation and fund manager selection two examples.

We do see some merit in tilting towards developed market equities over their emerging market brethren at the moment, with a slowing global economy tending to provide a friendly backdrop for this trade. Overall, that is precisely what our short-term package of investment positions tilts towards if anything – a slowdown in the global economy over the summer and continuing disturbance across capital markets. Catastrophe can be avoided and the longer term future, the one that matters for investors, remains plausibly sufficiently bright to warrant being fully invested as usual.

[1] https://www.brookings.edu/blog/order-from-chaos/2022/04/26/putin-just-tested-a-new-long-range-missile-what-does-that-mean/?utm_campaign=Brookings%20Brief&utm_medium=email&utm_content=211352319&utm_source=hs_email

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