Since mid-July, investors have had to deal with the conundrum of high inflation coupled with early signs of slowing economic activity. While available indicators have not been much help, the major central banks’ message – and resulting decisions – are crystal clear: Since inflation is too high and likely to remain so, a strong response is needed.
UK inflation in July significantly exceeded expectations. Headline inflation hit 10.1% year-on-year (after 9.4% in June) and core inflation rose from 5.8% to 6.2%.
Meanwhile, the Reserve Bank of New Zealand raised its policy rate again by another 50bp to 3.0%, saying “the Committee agreed it remains appropriate to continue to tighten monetary policy at pace”. The RBNZ revised up its inflation and policy rate forecasts.
Norges Bank, Norway’s central bank, also raised its key rate by 50bp in the face of much higher-than-expected – and well above target – inflation.
Fed: Mission far from accomplished
The minutes of the US Federal Reserve’s monetary policy meeting on 26/27 July confirmed that the Fed is still far from considering its mission accomplished.
While the tone was not particularly hawkish, the message left no room for doubt: Federal Open Market Committee members are considering slowing the pace of policy rate rises ‘at some point’. This may mean that the 75bp increases in June and July are unlikely to be repeated. However, they are also convinced that inflation will likely stay ‘uncomfortably high for some time’.
As a result, the FOMC will seek to slow GDP growth below trend.
Bond markets react
The 10-year UK Gilt yield rose by 16bp, driving up eurozone rates (by 11bp for the 10-year Bund yield to 1.08%, its highest since 21 July).
In the US, the yield on the 10-year T-note closed at 2.90%, its highest since 20 July, while the 2-year yield reached 3.28%, its highest since 14 June.
And the ECB? An interview with Isabel Schnabel, Executive Board member, showed her concern over inflation and highlighted a conclusion that appears shared by many central bankers: ‘Even if [the eurozone] entered a recession, it’s quite unlikely that inflationary pressures will abate by themselves.’
In the US, the president of the Federal Reserve Bank of Richmond had expressed the same idea even more clearly, by indicating that the Fed needed to keep raising interest rates until it was clear that inflation was running at its 2% target – even if the economy weakens.
We believe these comments are consistent with our assumptions about the Fed’s monetary policy cycle: That it will continue to raise rates, at a slower pace, but that the terminal rate, which we estimate at 4.00%, would be maintained for much of next year.
Growth: Slower for longer
Initial data from purchasing managers’ surveys (PMIs) sharpened the fall in long-term bond yields. Details are due next week. In view of the business survey numbers already available in the US and the eurozone, we think they are unlikely to show any improvement in sentiment and the outlook.
The markets’ reaction to these PMIs could be a test for central banks: If bond yields fall again because investors see the risk of recession as being more significant than inflationary pressures, further policy explanations will be needed. It seems that here too, education is a matter of repetition.
The annual Jackson Hole symposium on 25-27 August will provide Fed chair Jerome Powell and his counterparts with another chance to explain the importance of ensuring that inflation expectations are anchored.
This is all the more important since it is likely that energy supply difficulties could cause a sharp slowdown in activity in the eurozone later this year after resilient GDP growth in the first half. The US economy is expected to experience recession, i.e., a phase of growth below potential, only in 2023.
Hard economic data in China for July disappointed, showing activity slowing from June. The slight slowdown in industrial production was partly due to power cuts. Retail sales were much weaker than expected (at 2.7% year-on-year vs. a consensus at 5% and a rise of 3.1% in June). The pandemic-related restrictions put in place in early July were seen as the cause of the poor numbers.
All this followed a slowdown in GDP growth in Q2 (0.4% year-on-year after 4.8% in Q1) and disappointing credit distribution.
Against this background, the central bank announced a 10bp cut to 2.75% in the one-year loan rate and to 2.0% in the 7-day reverse repo rate.
It is clear to us that the priority for the Chinese authorities remains to support growth, faced as they are with both worsening difficulties in the property sector and a zero-Covid strategy that is likely to stay in place through next year unless an mRNA vaccine is developed or there is a sharp acceleration in the Sinovac booster campaign.
What should investors do now?
After the sharp rally in July, global equity returns this month have remained reasonably firm (2.7% as at 17 August after 6.9% in July for the MSCI AC World index in US dollar terms). However, these gains are starting to falter on the partial correction in the fall in long-term bond yields.
Since we expect yields to adjust further, we are significantly short duration. Indeed, we deepened our short towards euro sovereign bonds last week.
We believe our neutral stance on equities is justified, given the continued optimism over forward earnings growth amid the uncertainty over the macroeconomic outlook.