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Risks of recession rising

Market snapshot

04/07/2022
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The first half of 2022 finished with a further sharp fall in the equity market, with the S&P 500 recording its worst H1 in 50 years. More broadly, the source of angst for investors is shifting beyond inflation, which has dominated the past year, onto concerns around global growth.

What is happening in the US

Several US regional surveys showed declining business activity during June. More data for May also emerged with personal income and spending at the slowest pace this year, even accounting for the downgrade to April’s growth. After adjusting for inflation, May also saw the first negative spending growth this year. That is despite income growing quite robustly. The cost of home ownership in the US ‘states’, meanwhile, has risen to the point at which it seems likely that many prospective homeowners will have to abandon their plans to purchase a property for now. Mortgage refinancing has also slowed as rising interest rates have reduced the ability of US homeowners to lower their monthly outgoings by refinancing their mortgages at a lower interest rate.

Federal Reserve chairman Jay Powell told an audience at the European Central Bank’s annual policy forum in Sintra that he believes the Fed can restrain growth while avoiding a recession. That is a huge challenge bearing in mind that recessions are a somewhat inevitable consequence of the end of the business cycle. Recessions seem even more likely when the sharp increase in inflation requires an even sharper increase in interest rates. For now, data still seems to suggest that the employment market is tight. There continues to be about two jobs for every one person looking for work. Most surveys find respondents recognising that jobs are plentiful, although increasingly respondents are anticipating the labour market turning more negative.

Adding to the recessionary narrative have been drops in commodity prices. The biggest pain has been in industrial metals, which do not have a big or immediate impact on consumer price inflation, but wheat and oil prices have fallen back from their peaks a few weeks ago and that helps with the notion that inflation may be past its peak.

Oil is by far the most impactful factor for headline inflation. Oil was largely responsible for the unexpectedly high level of inflation during May, but the last few weeks make it easier to imagine that US inflation is starting to fall. That comes despite OPEC failing to decisively increase oil supply at their meeting on 30th June; instead, they acknowledged the risk that they wouldn’t be able to make their current targets. Meanwhile, US negotiators provided a downbeat update on talks with Iran over ending its nuclear programme and potentially bringing its oil supply back to the market.

With recessionary risks perceived to be rising and commodities signalling that inflation is ebbing, money markets no longer see the trajectory of interest rates as being inexorably upwards. Instead, the peak in interest rates has begun to be discounted at the February 2023 interest rate setting meeting. So far, there has been no acknowledgement that the Fed will indeed reduce the pace at which it is hiking interest rates and until it does the market will remain anxious.

What is happening in the UK

Concerns about UK growth are on a bigger scale and the political landscape has taken an uncertain turn following the departure of Boris Johnson. The pound rose on the day Boris announced he was stepping down, but was likely being moved more by European gas prices than UK politics.  And what of his successor? No doubt all would dearly like to cut taxes, but the current state of the public finances and projected rise in inflation, make that very difficult. That uncertainty reduces the market implications of this week’s political chaos such that any impact was barely discernible.

What will have more of bearing is GDP, which has already been declining for two consecutive months and the second quarter looks certain to contract. The potential for a summer of industrial action is putting further strain on activity, especially for the hospitality and retail sector. Investors are getting more bearish on the UK, with a Bloomberg survey showing close to three quarters of respondents expect a recession within a year and the pound at risk of touching early pandemic lows. UK retail sales fell 0.5% in May, which is the third monthly contraction in four months. Food sales were the main driver of the decline as consumers struggled with higher supermarket bills. Discretionary spending, such as household goods and at department stores, were down as well.

Rampant inflation in the UK is making households very nervous. The UK headline annual inflation rate accelerated to 9.1% in May from 9% a month earlier. Food prices, which are rising at the fastest pace in 13 years, drove the bulk of the pickup in inflation in May. Matters will get worse later this year when another energy price cap hike kicks in, with the Bank of England forecasting that price gains will surge above 11% in October

The silver lining is that underlying inflation excluding food and energy slowed to 5.9% from 6.2%, reflecting an easing in price increases from physical goods. Given the easing in core price pressures, the Bank of England is likely to stick with 25 basis point incremental increases in interest rates. Similar to the US, markets are currently expecting rate cuts to happen in Q2 2023, so most of the pain in higher interest rates would likely be felt this year.

Looking ahead

With recession risks and inflation numbers under huge scrutiny, markets are likely to remain sensitive and vulnerable in the near term. That said, a lot of the bad news has been priced in and sentiment has turned very bearish. Taking the US benchmark S&P 500 as an example, the good news is the average decline that occurred during past recessions – which were primarily driven by monetary tightening – was similar in magnitude to the downside that has occurred so far this cycle. As such, even if we are heading for a recession, a lot of the bad news is arguably priced in to equity valuations.

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

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