Market performance shows reasonable progress

Markets managed to break the difficult trend year to date and make progress towards the end of the month despite plenty of continued anxiety over inflation, interest rates and growth. There are great inconsistencies in the current environment, with widespread dissatisfaction despite generally low levels of unemployment and rising house prices (often a prime confidence builder) around the world. Inflation is the critical issue of the day and is inescapable in the press on a daily basis.

Inflation continues despite windfall tax

At the epicentre of the inflation show are energy costs and Ofgem’s current estimate of the price cap increase in October which implies a rise to around £2,800 – well over double the level in October 2021 – and would mark the highest share of consumer wallets on record (dating back to the 1950s). The government was forced to change tack in the face of this threatened increase, announcing a tax on the excess generating profits. The windfall tax had little impact on oil and gas stocks, which continue their march higher, as it is applicable only on UK profits. These form a relatively small share of the profits from the largest UK-listed diversified oil and gas majors – BP and Shell. More challengingly, it has impacted the renewables sector more at this stage which may moderate additional investment at a time when this is much needed as part of the energy mix.

The taxed profits will be put towards offsetting higher energy bills and will reduce, but not fully negate, the impact of the October rise. It does, however, represent a meaningful injection of spending into the economy at a time when demand is already exceeding supply and causing uncomfortably high inflation. Pressure is growing on Boris Johnson from the back benches to go even further. Having survived the indignity of a ‘no confidence’ vote, with over 40% of Tory MP’s opposed to Johnson’s leadership, the PM may look to appease some of his critics by cutting taxes to further alleviate the pressure on households.

The hospitality sector continues to expand despite rising costs

Elsewhere in the economy, the Purchasing Managers’ Indices (PMIs), a well-recognised barometer for demand and wider corporate health, currently reflect an environment in which growth remains firmly positive but slowing. That slowdown was generally a little more pronounced for the manufacturing sector, reflecting the shift in demand away from the goods that had sustained people during the pandemic and towards the experiences they have been missing out on. The most notable experiences being holidays and eating out (areas where price insensitivity is high and accordingly a not insignificant influence in the inflation picture in the short term).

These areas are an exception to the greater resilience of services which remained above 50, implying the sector continues to expand, but at a slower pace (a reading above fifty suggests the service sector is expanding, while a reading below fifty suggests the service sector is in contraction). It would be easy to dismiss the reading as an anomaly, but as UK consumers were saddled with higher energy bills and higher national insurance deductions from April onwards, May’s data gives us the first impression of how significant this is. The question now is whether the easing of demand serves to reduce price pressures. The survey reported that companies are finding it harder to pass on cost increases to consumers.

All this complicates the hand of the Bank of England, which would like to raise rates more in order to respond to the inflationary threats but will be mindful of hurting the economy too. In the absence of any evidence of the employment demand weakening, it seems unlikely that the Bank of England can be too cautious about interest rate increases in the very short term.

Further windfall taxes considered internationally

Outside of the UK, other governments are considering their own windfall taxes. Hungary, which remains a stumbling block in terms of building a consensus to frustrate Russia’s oil sales, announced multinational companies would be required to turn over the most of what prime minister Viktor Orban described as their “extra profit”. This will be used to subsidise utility bills and pay for the cost of modernising the Hungarian armed forces. In China, premier Li Keqiang convened an emergency meeting with thousands of representatives from local governments, state-owned companies and financial firms. He called upon them to stabilise growth, describing the current level of activity as worse than in the immediate aftermath of COVID-19.

What is happening in the US

In the US, the economy continues to be supported by strong demand but is showing some signs of weakness. Employment data remains robust with 390,000 non-farm jobs added in May (ahead of consensus expectations of 320,000) but warnings of recession continue to grow. Consumer confidence fell in May as, apparently, did Elon Musk’s confidence. The Tesla chief warned he has a “super bad feeling” about the economy, indicating 10% of Tesla workers may face losing their jobs. Though based on previous comments, Musk’s comments ought to be taken with a pinch of salt, the proposed cuts are nonetheless concerning given the demand and long lead time at Tesla.

Turning to the housing market, momentum has stalled due to the inflation uncertainty outlined above and higher bond yields, this trend has been more pronounced in the US where bond yields influence financing cost and activity. A second reading of first quarter US gross domestic product (GDP) revealed a revised-down figure for residential investment, again remaining just modestly positive. Residential investment is not a big category of GDP, but it does tend to be watched closely. This is because it is quite labour intensive and drives a lot of subsequent economic activity (for example, moving, furnishing) as well as ultimately aiding the supply side of the economy by supporting labour mobility.

The silver lining

Having waded through a lot of potential gloom, it is worth reiterating that markets actually performed reasonably well towards the end of May. Much of the news – while understandably headline grabbing - was expected and, after a few troubling weeks, markets were already depressed. In times of weak market sentiment, small changes can have a more meaningful impact.

As we approach the end of the quarter investors remain very cautiously positioned and markets should benefit from rebalancing flows from pension funds with very prescriptive strategic asset allocations.

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