The week in review – 19th June 2023

Federal Reserve building in Washington, D.C. - Financial Markets Review

Market conundrums amid volatile growth

Equity markets moved higher last week, despite central bank hawkishness. We had another 0.25% rate rise from the European Central Bank (ECB) and, although the US Federal Open markets Committee (FOMC) left rates unchanged, they gave us and through their ‘dots plot’ they gave us strong hints of at least another 0.25% hike in July. They also indicated their expectation for rates to stay higher for longer.

Since 23 March the date of the last FOMC meeting, the S&P 500 has gained 10%. The backdrop to that last meeting was the Silicon Valley Bank collapse, when many thought the financial system was close to a dangerous precipice, and that a rash of corporate bankruptcies were just moments away. We have made great strides since then. But the west’s continued growth is not assured, precisely because central banks still have more work to do to quell second-round inflation pressures from the self-enforcing dynamics of wage rises. The Fed and the ECB told us that last week, and this week, the Bank of England (BoE) will most certainly raise UK rates. Yet, as we said earlier, markets appear to be behaving as if growth is set to rise sharply, despite institutional investor sentiment surveys showing only a little improvement in confidence.

We noted how expensive equity markets had become in May and, since then, it has become more extreme. The S&P 500 is now 28% more expensive than our historical model of earnings and yields would suggest, a level that has not occurred in over 20 years. Such optimism is only justifiable if we are moving into a significantly higher real growth and inflation environment, as was the case during the second half of the 20th century. For this to happen, Oone would have to think that central banks will give up on constraining inflation to their targets through higher rates in the medium term, a judgement we think is still way too early to make now.

Have we already reached ‘peak oil’?

Oil prices took another step down in the early part of last week, as Brent crude, the international oil benchmark, dropped to just $71 per barrel (pb) during Monday trading and despite a slight mid-week recovery, prices ended the week below where they were a week ago. After peaking at more than $110pb in June 2022, oil demand has severely weakened and prices have consistently fallen, only occasionally punctuated by sputtering short-term relief rallies. Since the end of last year, Brent prices have been consistently lower than on the eve of Russia’s invasion. Weaker demand is the more important factor, though. Western economies have been slowing for some time. Lately, the biggest disappointment has been China, where which has continued to disappoint over the last few months. Both OPEC and the International Energy Agency (IEA) still expect Chinese oil demand to be a big factor in the second half of 2023, but many market analysts have their doubts.

Underlying the weak demand forecasts is a structural decoupling of economic activity from fossil fuels. While Beijing has pushed environmental policies for a long time, when China has most needed growth its policymakers have generally resorted to energy-intensive sources like industrial production. This year, policy support has been much more focused on less carbon-heavy sources. Moreover, this decoupling is happening across the world – with US and European policymakers pushing hard toward green investment.

On the one hand, you might think – as the IEA seem to suggest – that there is currently over investment in oil and gas, which will result in an oversupply when regulatory and societal changes kick in, and potentially an array of stranded assets which could be damaging for the financial system. On the other, you might just think markets do not believe net zero targets will actually be met. Environmental backsliding since the war in Ukraine started (particularly in the UK and Europe), as well as past failures to meet targets, back this up. Neither are comfortable scenarios to be in, but the latter would clearly be worse for the world. As well as the obvious environmental and social crises, extreme weather would likely destroy productive capacity. That is to say, over the long-term, oil demand will have to come down one way or the other – through choice or circumstance. Short-term upsides in the oil price might still be had, but the longer-term pessimism is now definitely in view.

A new sovereign debt regime for emerging markets

The lack of an international bankruptcy regime has plagued developing nations ever since countries started borrowing. However, no international agency or group of countries or group of financial institutions has ever been able to agree a workable framework. Recognition of these troubles is one of the reasons for a pending New York state bill on sovereign debt workouts for emerging market countries (EMs), which was delayed last week. The bill is (unsurprisingly) controversial: defenders point to its ability to streamline lengthy repayment disputes while preventing debts from crushing poorer nations; critics say it will only worsen EM borrowing rates and open up a legal can of worms.

Both sides at least agree that some system of rules is needed for sovereign debt. The most controversial parts of the proposals, though, are measures which limit how much money investors can recoup when a nation defaults. The resulting framework would be very forgiving for borrowing nations – compared to what happens now, at least. Some have even pointed out that governments could unilaterally extend the maturity of their debt without penalty, allowing them to restructure debt repayments without ever officially going into default. That would arguably give issuing nations discretion to decide whether they are in default or not.

EMs are clearly struggling with foreign-denominated debts in the post-pandemic world. It is highly likely Pakistan will officially restructure its debt soon after agreeing terms with the IMF. Meanwhile, Ukraine will need a restructuring in due course. Unfortunately, it is hard to see how these lenient measures would do anything other than move the current problems around.

UK COMMENTARY

  • UK gross domestic product (GDP) – as reported by the Office for National Statistics (ONS) – increased by 0.2% in April following the 0.3% contraction in March.
  • The services sector grew by 0.3% overall, and was the main contributor to the positive number. Consumer-facing services (which includes food and beverage serving activities, travel and transport, and entertainment) grew by 1.0% in April, following a fall of 0.8% in March. However, production output fell by 0.3%, while construction sector output dropped by 0.6%.
  • The average rate on a two-year fixed rate mortgage in the UK increased to more than 6.0%, up from 5.26% at the start of May. This is a level last seen after the chaos of the mini budget in September 2022.
  • The ONS reported the UK unemployment rate for February to April increased to 3.8%, up from 3.7% in the previous quarter but down on the 3.9% reported last month.
  • UK wage growth continued to strengthen in the February-April quarter, prolonging the Bank of England’s difficulties in trying to cool inflation without causing significant economic contraction. Regular pay (excluding bonuses) rose by 7.2% per year in the quarter according to the ONS, up from 6.6% in the November-January period.

NORTH AMERICA COMMENTARY

  • The US Labor Department reported that inflation, as measured by the Consumer Prices Index (CPI), dropped to an annual rate of 4% in May. This was the lowest reading since March 2021, and down from April’s 4.9%.
  • US core inflation, which removes the volatile food and energy components, fell to an annual rate of 5.3%, down from 5.5% in April. US energy prices were 11.7% lower in May than a year ago, while the food prices index increased 6.7%.
  • The US Labor Department also reported that the Producer Price Index (PPI), which records the ‘final demand’ prices charged for consumption by goods makers and service providers, fell by 0.3% in May, suggestion inflation ‘stickiness’ had subsided somewhat. The fall was largely due to a 1.6% drop in prices charged for goods such as energy, while services prices rose 0.2% in the month.

EUROPE COMMENTARY

  • The European Central Bank (ECB) voted to raise its three key interest rates by 25 basis points, with the main refinancing rate for operations rising to 4.0%.
  • The marginal lending facility (used by commercial banks for short-term borrowing from the ECB) was raised to 4.25%, while the deposit facility rate (paid on commercial bank deposits left at the ECB) moved to 3.5%.
  • Eurozone inflation was recorded at 6.1% for the year to May, down from 7.0% in April, but three times higher than its medium-term target of 2%.

ASIA COMMENTARY

  • China’s central bank, the People’s Bank of China (PBoC), lowered its medium-term borrowing costs for the first time in ten months, in an attempt to protect its economy from a potentially sharp downturn. The PBoC reduced the rate on one-year medium-term lending facility (MLF) loans by 0.1% to 2.65%.

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