Good news are usually good news, but when it comes to the fight of inflation, they could start be interpreted by financial markets as "bad" news, in the sense that central banks will have the perfect excuse/reason to raise interest rates even higher. Can markets withstand another 75bp or 100bp rates increase in the next 3-6 months? We find it difficult to believe. Below we will try to explain in a simplistic manner, that the surest way to bring down inflation and stay there is to attack demand, which eventually will lead to higher unemployment, lower wages, lower company profits and perhaps a recession.
Prices of consumer goods and services move according to the demand and supply balance, in free economies. If demand is higher than supply , prices move higher (inflation) and when supply exceeds demand, prices fall (disinflation). In 2020, the supply of many goods and services almost ceased to exist, but demand was there "in principle". The opening of the economies in 2021 and beyond has made this pent-up demand emerge and the frustrated consumers rushed to go out, travel, buy a new car, a new home etc. And to some extent, this extravagant spending has continued until now in specific sectors such as entertainment, travel and leisure.
The gradual increase of supply could not keep up with the pace of demand and the end result can be seen in our everyday lives : high inflation. A lot has happened since 2021 and looking at the supply side, one can say with certainty that the major issues have been resolved and supply-related costs are significantly lower than a year ago. Energy, freight costs and commodities are down significantly since their peaks in 2021 and 2022. This has helped inflation move in the right direction. Companies have enjoyed the lower input costs but have not reduced their prices , as they see strong demand, with the end result being high profit margins and consequently high profits, at the expense of the consumer. But there is always a tipping point, when the consumer revolts. And demand will eventually come down, especially if interest rates continue to move higher.
Central banks can only control the demand side of the equation. With their main tool, which is the level of interest rates, they are trying to moderate demand for goods and services as people find it more costly to borrow in order to spend and corporations face higher interest expenses and cut their spending budgets to offset this. The higher the interest rates go, the higher the impact on demand is expected to be. The FED's rates are already above 5% and the ECB's are approaching 4%. But demand is yet to move significantly down. And the paradox is that the more good news we receive about the economy, the higher the probability is that demand will stay strong and inflation will not fall. The longer demand is staying strong, the higher the interest rates will have to be moved by the central banks, which will increase the probability of tipping the economies finally into a recession.
We had a set of good US data last week: The final reading of the US Q1 GDP was stronger than estimated in the first revision from a month ago, coming in at 2.0% vs 1.3% previously reported. Looking into the details, the picture relative to the fourth quarter of 2022 is of a pickup in household spending on durables and services. We have to note that this period covers until end of March, when we had the implosion of banks in the US and Europe. The results of this will be shown in the announcement of the Q2 report, to be published in about a month. More positive news this week also came from the drop of weekly initial jobless claims to 239k, from the 260k levels they had remained for three weeks. The headline number looks good, but we should mention that almost all of the drop comes from just two states (California and Texas), which means that data might have been skewed by idiosyncratic factors. Lastly, the housing market showed further rebound with new home sales jumping by more than 15% on a monthly basis. Home prices fell again, which has helped demand lately despite the high level of mortgage rates.
Inflation in the Eurozone continued to move lower in June. The headline number was announced at 5.5%, down from 6.1% in May and it was slightly better than expected. The most important Core CPI, was also announced a little better than expected, at 5.4%, but the fact remains that it was a little higher than May's figure (5.3%). Looking into the details, food and beverage prices have moved down, but travel relates services continue to provide inflationary pressures. The ECB is expected to use this report in order to hike rates when it meets in about two weeks time.
China's PMI Manufacturing continued to be in contraction territory, in June. It was announced at 49.0 , slightly higher than the 48.8 of the previous month and in-line with expectations. The Services PMI fell to 53.2, down from 54.5 in May, and was also in-line with the expectations. The data overall gave more fuel to the speculation that the Chinese authorities will embark in fresh monetary and fiscal stimulus. As we have said several times, China's low inflation as well as its fiscal discipline of the last two years gives space for rate cuts and an increase in government spending, the exact opposite of Europe where government spending is reduced and monetary policy is getting tighter.
Equity markets rebounded towards their recent highs in Europe and the US. The good macro data with respect to the consumer's health (GDP and employment) propelled markets higher, despite the rise of bond yields, which up to now has been an obstacle for further gains. The US and European indices advanced by 2% on average during the week. Swiss stocks underperformed with a small increase of 0.5%, as investors focused on the riskier part of markets which are closely linked to the economies (autos, banks, materials).
Bonds lost ground and yields rose to the levels seen at the end of May. The US 2-year yield rose close to 5% again, as the market is starting to believe that the FED is not done yet, with a hike in two weeks from now an almost certainty. Interestingly the longer duration bonds reacted less aggressively than the short end, as the market will start to assign a greater probability of a recession if the consumer stays resilient and continues spending. The longer duration bonds offer good protection for a recession or a unexpected market turmoil, but their price could suffer if interest rates move signficantly higher.
Chart of the Week : Can Chinese equities rebound from the lows of the year ?
This is an interesting chart, produced by UBS, which shows the CSI 300 index and the key events that took place in the first half of this year. What started with a significant rally in January, as the country was exiting the lockdowns turned into a continuous fall, with only some relief rallies on the way. The reality is that the economic data since end of April have been weaker than expected. But it is also true that there is huge political pressure in the US on pensions and institutional investors to avoid investing in China, at this stage. This has kept the Chinese local investors alone in the game, and they are also reluctant to enter the market again after two years of disappointing results. The end result is that valuations are now even cheaper than they were at the start of the year, as profit growth is still expected to be about 10% in 2023. There will be a point when Chinese equities will be resurrected again and money with flock into the market driving it significantly higher. When and from what levels is totally unknown.
Disclaimer
• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.
• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.
• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.
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• Sources: Chart of the Week : UBS
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