Posted on November 10, 2022.
It is the spectre of inflation that has driven central banks to tighten monetary conditions and the root cause of all the equity losses and bond price falls this year. Stock markets have priced in the known news over inflation and there is a growing view that headline inflation in the most influential market, the US has peaked and therefore a new threat is that the Fed will over shoot with rate rises.
US inflation was 8.3% in August and came in at 8.2% in September. This is a marginal reduction but less than expected but down from June’s 9.1% high. This was still above expectation so markets fell off. Core inflation which excluded food and energy went up from 6.2% to 6.6% again above expectations. Any sticking of core inflation will put pressure on the Fed to maintain its aggressive stance on raising interest rates. US inflation figures for October are published on Thursday with expectations that headline inflation will fall to 8.1% but core inflation rise to 6.7%.
Jerome Powell, The Federal Reserve Chair will be focussing on US data to make future policy calls. Expectations are that while core inflation has not yet reduced, when it does there will be a faster fall in overall inflation. Fund Managers and analysts suggest US inflation will be back to 2.5% within 12 months.
Stock markets are not expected to deteriorate much more from current values as recession could be relatively mild and stock markets have priced this in already. Stock markets outside the US have enjoyed an uplift in values this past month. Bonds have mispriced due to near zero interest rates and have reacted to yields rising to match the market demands of an inflationary world. For a safe asset, gilts and bonds have been incredibly volatile especially long dated credit. Once bond yields stabilise, we will have far more attractive investment conditions.
The US housing market is showing pressure from the Fed rate rises. US mortgages rates are up and this is impacting new house sales. The current US mortgage rate is 6.81% while a 30-year fixed mortgage is 6.92%.
In 2007/08 when there was last a housing crash in America, this was promoted by massive oversupply and very easy money. This year there is far less stock available so the lack of supply will protect prices.
In 2008, subprime lending was high but this has changed now. Subprime lending is hard to obtain and only a small proportion. The superprime sector is now predominant. This is supported by a robust and well capitalised US banking system.
The US economy is still creating jobs. There were 315,000 new vacancies in August, 263,000 new jobs in September and 239,000 in October. Unemployment was 3.5% in September and October which is down from 3.7% in August. Everyone who wants a job can get one as only half of vacancies are being filled.
The Fed is watching the unemployment rate in order to predict wage inflation. With job vacancies still strong the Fed will not rush to pausing rate rises. Any increase in unemployment will likely mean that interest rate rises will be less as wage inflation will be less. A cooling economy will be better for rate hikes.
The US markets are better placed to weather the recession storm and therefore likely to be the first economy to lead the way out of recession. For this reason, we are retaining an overweight position in US equities and will be re-introducing US treasuries to the portfolio.
Europe is focussed on getting through this winter’s gas demands by filling its gas storage capacity and so can avoid being at all reliant upon Russian energy supplies. Russian gas is being replaced by US LNG as well as Algerian and Norwegian gas. US LNG is being supplied to the UK and then piped to European storage as the UK has so little. European gas storage is now full.
If winter is a normal one and so far, weather forecasts are suggesting a relatively mild winter, so black outs are expected to be avoided. The funding of gas storage has been expensive as will be the energy price cap policy of the UK and German governments. The German governments plan could cost €200bn, while the original 2-year Liz Truss energy cap plan was expected to cost up to £150bn. This has since been reduced in scale as gas prices have fallen and the government wanting to reduce their debt costs.
Both the UK and German government want to shelter the public from excessive gas prices and has been seen by markets as vital to the economy and will help avoid a deeper recession.
The position of the UK government has shifted dramatically since Jeremy Hunt took charge of the Treasury. This has only been further reinforced when Rishi Sunak become Prime Minister. Jeremy Hunt has the support of the BoE and is seeking significant cost reductions in government budgets and reverse nearly all tax cuts in order to balance the UK budget over the years to come while reducing the nation’s debt pile of £2.54tn which as a percentage of annual GDP is 95.6%. This will be hard in the face of a recession and a cost-of-living crisis.
Septembers failed mini-budget put the UK’s finances under the spot light and has resulted in higher borrowing costs. Consumer spending and therefore corporate earnings are expected to fall and that the UK will underperform other G7 counties in 2023. Despite this outlook, UK unemployment is only 3.5% and the employment rate is 75.5%. There are 1.2 million unfilled job vacancies and 1.5 million people unemployed so almost everyone without a job could have one. Since Covid 500,000 people have left the workplace either due to a lifestyle chance, ill health, early retired or just not working.
The UK stock market has suffered like all others this year. Starting January 2022 at 7384 points it now stands at 7304. All predictions are for a recession in Europe and that stock prices reflect a relatively mild recession. The impact of wage inflation over the next year will have an influence over interest rate policy and a fall in employment would be healthy for lower borrowing costs. That does not at this stage look obvious in the US with new job vacancy numbers still strong.
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