Market volatility expected to continue

Equity markets staged a recovery through July amidst a busy period for earnings releases. The share of companies beating earnings forecasts (Beats) has been a little below normal at just over 70% in the US (it is normally 80%) but given the challenging background this should be seen as a positive. Perhaps more informative is the guidance that companies issue for future periods, which was quite changeable and possibly flags the continuation of some volatility in the short term.

Taking a pulse check on consumer spending

Financial companies have reported that consumers are still spending well, have adequate cash balances and show few signs of stress. Part of the reason for high levels of spending is, however, the high price of goods and services. Hence, when listening to retailers, there does seem to be, in general, a more cautious tone. So, the focus has also been on retailers to see what people are buying. Amazon sounded pretty upbeat on consumer spending – both now and in the future. However, Walmart, something of a bellwether for US retail sales over the last decade that caters to cost-conscious shoppers, sounded a way more cautious tone having seen its sales mix shifting from higher margin general merchandise towards lower margin groceries. This suggests that price increases in life’s essentials are beginning to feel the pinch from higher prices for non-discretionary spending.

What is happening in the US

The more cautious tone from Walmart, may bode ill for the future and while the back-to-back quarterly GDP contractions seen in the US meet one definition of a recession, the National Bureau of Economic Research is responsible for making the official call. One of the factors it looks at is employment, which remains strong. Treasury secretary Janet Yellen stated: “Most economists and most Americans have a similar definition of recession: substantial job losses and mass lay-offs, businesses shutting down, private-sector activity slowing considerably, family budgets under immense strain. In sum, a broad-based weakening of our economy. That is not what we’re seeing right now.”

However, nervousness about demand over the coming months remains. The Conference Board consumer survey showed a continued slump among consumers who may want to make large purchases and the lowest share of consumers in more than a decade that plan to buy a home in the next six months. Housing is another bellwether for the economy as it has a high multiplier – with each house built, there is a lot of economic activity (construction, decoration, sale, moving, furnishing, and so on). Consistently weak housing data, including sharp reductions in new and pending home sales, suggests that higher mortgage rates and high prices are discouraging new housing activity.

It may take some time for the impacts of higher prices and the increasing cost of capital to filter through to the real economy. The US Federal Reserve approved its second consecutive 75 basis points (bps) interest rate hike at the July meeting, taking its benchmark rate to a range of 2.25-2.5%. Investors were largely expecting the move and were cheered by relatively dovish comments by Fed chair Jerome Powell that future rate increases would depend on the data.

This new stance of data dependency was greeted positively by the market, which sees evidence of the economy slowing and was already sceptical that the Fed would be able to reach its expected interest rates trajectory of 3.8% by the end of 2023. Bonds and equities rallied at this apparent sign that Powell was ready to respond to falling inflation and a slowing economy, but they may be being premature in this assessment. Food inflation should slow in response to falling soft commodity prices, and some shortages are being addressed with manufacturing supply times shortening. But the labour market remains tight and house price growth has remained rampant, supported by shortages of supply, even as demand has ebbed.  

What is happening in Europe

In contrast with the US, eurozone GDP expanded much more than expected in the second quarter, driven by pent-up tourist activity in Spain and Italy, while household spending was still resilient in the region. But Germany stagnated, reflecting the challenges in exports and industrial activity as global, and particularly Chinese, demand slowed.

Inflation on the continent has not seen a peak yet, with the latest eurozone CPI rising to 8.9% from 8.6%. Aside from surging energy costs, underlying prices (core CPI) also accelerated. The spike in natural gas prices in recent weeks means energy prices will remain a big challenge for consumers and businesses as winter looms and the European Central Bank, (ECB) has joined the Bank of England, (BoE) and the Fed in hiking interest rates, ending the era of negative interest.

Back at home, the BoE, painted a particularly gloomy picture warning of a 15-month recession and 13% inflation at its peak. The Monetary Policy Committee (MPC) raised interest rates by 50bps at its latest meeting. The pressure from commodity prices has previously been something that BoE governor Andrew Bailey felt was beyond the scope of the MPC to influence, therefore justifying a slightly more dovish stance. However, the BoE does acknowledge that the tight labour market is putting upward pressure on inflation and it is looking to slow demand to the extent that it creates some slack in the labour market and reduces wage-driven inflation. The main question is whether the BoE will hike by 25bps or another 50bps in September. The Bank’s handling of the recent crisis has been criticised by Prime Minister hopeful, Liz Truss who is the front runner to take the top job following Boris Johnson’s resignation, polling favourably with the Conservative Party base, though rival Rishi Sunak has been quick to warn that Truss’ proposed reversal of National Insurance rises and other tax cuts are likely to fuel inflation further.

Pelosi’s trip causes heightened tensions

Away from the mundane world of interest rates, US House speaker Nancy Pelosi’s trip to Taiwan sparked major geopolitical tensions between Taipei, Beijing and Washington. The US has been deliberately ambiguous in its relations with China and Taiwan, acknowledging the mainland government as the sole legal government in China while avoiding expressing an opinion on the sovereignty of Taiwan. China had been attempting to deepen its economic integration with Taiwan in the hope of achieving a diplomatic unification, but since 2016 those efforts have been undone by President Tsai Ing-wen who has sought closer ties with the US and to reassert Taiwan’s independence. Suppression of democracy in Hong Kong has also damaged the pro-unification movement within Taiwan, raising the question of whether China would be prepared to try and achieve reunification by force.

Pelosi, who is currently third in the US presidential line of succession, is the highest-ranking US official to visit China in two decades. It comes after President Joe Biden seemed to confirm that the US would defend Taiwan militarily before his team walked back the remarks. Her visit prompted a show of force from China with military drills and missile tests. Tensions seemed to weigh on Asian markets and whilst most commentators do not believe either side would willingly engage in conflict, they feared that these exercises could lead to an accidental outbreak of hostilities. 

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin)