To say you didn’t see a correction coming – or at least a stall in over-enthusiastic risk markets – would simply be naive. Exuberance had clearly taken over markets recently, especially equities, driving them higher for weeks in spite of numerous warning signs on the horizon. This week was a reckoning with equity markets globally selling off, although if this is the worse it gets, then the bulls could be off and running again before you blink an eye. I have my doubts though, because central bank tightening will do its job at some point, which will be sooner rather than later at this point in the cycle. Several G10 banks raised their overnight bank rates this week, amongst them the SNB, Norges Bank, and the Bank of England, following increases in recent weeks by the ECB, the NBA and the Bank of Canada. The reality is that core inflation remains sticky in many parts of the world even as central banks apply the brakes increasingly hard, and this is troublesome to say the least. The inflation mandate is the purview of central banks in developed economies, but central banks really aren’t getting much help from governments as far as fiscal constraints. There is “leftover” fiscal stimulus from COVID relief in many economies, and this is working against the efforts of central banks. I don’t recall seeing politicians anywhere discussing fiscal constraints to help fight inflation, in most instances because this is generally a form of political suicide. In fact, many elected officials can’t shake the “spend, spend, spend” mantra, effectively offsetting at least some of the monetary policy tightening being undertaken by central banks. About the best we can hope for from our elected officials today is a cheerleading role and wishful thinking. For example, consider the case of UK PM Sunak, who must be really feeling the heat from his “inflation will be halved by year-end” statement a few months back.
With core inflation remaining sticky, we are likely to see more rate increases ahead. Even the Fed, which paused its increases in June, is on the record saying that it intends to raise the Fed Funds rate twice more this year. Yes, it is inevitable that central banks will keep tightening the screws, almost certain at some point to bring their economies to their knees. Whilst the US arguably has a bit more room to manoeuvre, the UK and EU remain on a knife’s edge, with their economies virtually in a holding pattern and likely to head south soon. The UK clearly remains very vulnerable for a variety of reasons, some self-inflicted. At the moment, there’s simply not much to get excited about economically, although this doesn’t keep the greater fool theory from applying in that risk prices will keep heading higher so long as there is at least one buyer willing to pay more for an asset than the last (fundamentals be damned).
If I were to offer an investment recommendation (and I can’t because I am not an investment advisor, so ignore this….or better yet, do the opposite), I would use this opportunity to write covered calls on your individual names, think about locking-in short-term yields which remain attractive, and covet your cash.
MARKETS THIS WEEK
Equities took it on the chin, but let’s start by looking at the government bond market. As you can see in the table below, the 2-10 year yield curves are now inverted in the UK, the Eurozone and the US, with the inversion increasing sharply in all three economies over the last month. Also note the sharp increase in 2-year yields over the last month, especially in the UK, as May CPI surprised and then the BoE responded with a jumbo increase in the Bank Rate this week. At the same time, 10-year yields have barely moved higher (or have even declined in the case in the Eurozone), an indication of investors’ sentiment regarding the direction of each economy down the road.
You can also see the CPI May YoY figures in the table above, with all three economies – but especially the UK – unable to work inflation back down to the target 2%. The way I see it, the UK is by far in the most precarious position, and will almost certainly experience a severe case of stagflation because inflation looks as if it will take longer to contain as the economy struggles to tread water. However, the yield curves in all three economies are signalling a slowdown ahead. Weakening oil prices in spite of OPEC+ cutting supply are another indicator of expectations regarding future global economic growth. Perhaps the one thing that has shocked me more than any is the resiliency of Sterling. If you focus a moment away from the expectations regarding the relative trajectory of interest rates in each economy (which I understand), betting on the UK – and Sterling in the intermediate term – looks like a loser’s wager to me at the moment.
If you would like to see the more gory details of performance by asset class / market index, go to the section “The Tables” below.
WHAT HAPPENED THIS WEEK THAT MATTERED?
UK inflation for May came in much hotter than expected mid-week (core CPI 6.5% YoY, up from 6.2% in April; see here), setting the stage for the Bank of England’s unexpected 50bps increase in the overnight Bank Rate the following day (see “Monetary Policy Summary, June 2023”). Investors and economists had been leaning towards a 25bps increase, but the hotter-than-expected May CPI read might have sealed the deal in favour of a more hawkish increase. This was the 13th consecutive time than the Bank Rate had been increased dating back to December 2021. Having now reached 5.0% – its highest level since April 2008 – and with more rate rises expected, the U.K. will likely face a “hard landing” in the coming months, as monetary policy clamps down on demand and growth. The culprits are a combination of a very tight labour market, especially services, and the BREXIT hangover as the country struggles to remain economically relevant on the global stage by going at it alone (post-EU exit).
Stateside, Fed Chair Jerome Powell made his biannual pilgrimage to Congress on Wednesday and Thursday, saying nothing new but providing a host of congressional members with political fodder for the future. The value I extract from this dressing down is nil, a complete waste of time if you care about economics and the direction of monetary policy in the US, and have been paying attention. I heard nothing new, although Mr Powell did reiterate that the June pause would likely be followed by two more increases in the Federal Funds rate this year, and that the current QE programme (circa $1 trillion/annum) would continue. Other than the macroeconomic outlook and Fed intentions with respect to monetary policy, there was also a fair number of questions about banks and bank regulation. Mr Powell indicated that the Fed is looking at this carefully in light of the March bank crisis, and is likely to tighten the capital and / or liquidity requirements of banks with $100 billion or more of assets (whereas I understand the threshold is currently $250 billion).
The tables below provide detail across various global and US equity indices, the US Treasury market, corporate bonds and various other asset classes.
Corporate bonds (credit)
Safe haven and other assets