The factors underpinning recent market moves have changed rapidly: Fears of an overheating of the US economy and concerns over China that dominated much of August seem to have given way to an ideal scenario of inflation seemingly under control, reasonable growth, and Beijing taking a firmer hand to stabilise China’s economy, particularly the weak property sector.
Should we celebrate the return to a ‘Goldilocks’ scenario where levels of growth and inflation provide a perfect environment for risky assets? Movements in equity and bond market suggest it may yet be a little early to pop the champagne corks.
Central banks are pursuing their ‘meeting by meeting’ approach on monetary policy decisions that will be ‘data-dependent’. But what are the economic indicators telling us?
Ongoing slowdown in the eurozone
In August, the eurozone composite purchasing managers’ index (PMI) fell to 46.7, its lowest since November 2020. This was due to slower activity in both the manufacturing and services sectors. While the services PMI had recovered between December and May, it suddenly fell from 50.9 in July to 47.9 in August, marking the first time since December 2022 that services activity contracted, with a particularly sharp decline in Germany and France.
The composite PMIs in June and July had raised fears of a decline in third-quarter GDP growth from the modest 0.1% in the second quarter.
Other business climate indicators (for the eurozone as a whole and for the bloc’s major economies) have highlighted a drop in demand and depressed order books.
US – Rewriting the textbooks?
While the eurozone seems to read like an economic textbook – restrictive monetary policy slows down growth, especially via the channel of credit to the private sector – the resilience of US growth is undermining market expectations and confounding economists.
Recent US indicators have left the impression of strong activity this summer. The Atlanta Fed’s GDPNow forecasting model, including data available as at 6 September, gives a running estimate of Q3 GDP growth of 5.6% annualised, up from 2.0% and 2.1% in the first and second quarter, respectively.
Among the GDPNow indicators that explain the acceleration since mid-August are employment, industrial production, retail sales and, most recently, the ISM services index. This surprised to the upside on 6 September, leading to upward pressure on bond yields.
Exhibit 4 shows that the US economy is harder to read than that of the eurozone despite the US Federal Reserve launching its monetary policy tightening cycle five months earlier than the European Central Bank, hiking rates further (+525bp versus 425bp) and raising its main policy rate higher (5.50% for the US federal funds rate against 3.75% for the ECB deposit rate).
Comparing the level of interest rates on each side of the Atlantic is not necessarily the most illuminating approach, though.
On the one hand, the degree of policy tightening is measured against the macroeconomic fundamentals of each economy. As Fed Chair Powell noted at the Jackson Hole symposium in August: ‘We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint’.
On the other hand, the ECB had to exit from an exceptional policy of negative key rates that profoundly has changed the behaviour of economic agents and financial actors.
First signs of the consequences of tightening in the US
As in July, the US employment report for August signalled a softer labour market, a trend that now appears to be the most favourable for investors.
At 187 000, net job creations came in close to market expectations, but the downward revision of the figures for the previous months sent the 3-month average for job creations to only 150 000 from more than 300 000 in the first quarter.
The pace of job creation in last three months is the slowest since the end of 2019 and, in our view, corresponds to a normalisation of conditions in the labour market.
The steady rise in labour force participation rates is part of the same trend of rebalancing job supply and demand. The rise in the unemployment rate from 3.5% to 3.8% should not be overinterpreted, but the steady slowdown in hourly wages is a positive signal too, even though, at 4.5% year-on-year, wage increases remain dynamic.
Moreover, a phenomenon that will be crucial in coming quarters is the boost to household consumption from spending abnormally high savings that had piled up during and just after the pandemic.
Here too, there is considerable uncertainty, particularly with regard to estimating how large these ‘excess savings’ are. The most likely conclusion is that the money in these particular piggy banks will run out by the end of the year.
Against this background, although we have revised up our estimate of GDP growth for the third quarter, we continue to expect a slowdown in late 2023 and early 2024.
Being long bonds is justified
The latest developments and outlook for inflation have assuaged market concerns over a further spike in inflation (excluding the risk of external shocks).
From this point of view, the outlook for inflation seems to be becoming clearer, even if it will take time to return to a level compatible with central banks’ inflation targets. Some progress has already been made in emerging markets (EM), allowing for initial (in some case, larger-than-expected) rate cuts by some EM central banks.
As for GDP growth – and thus business activity and firms’ earnings – the current consensus scenario looks to us to be too optimistic, especially for the US economy. The coming months should see a slowdown in business activity and unchanged monetary policies (before rate cuts) in the major developed economies.
This should be supportive of fixed income assets which currently make a large contribution to risk in our portfolios. We are considering adding to our positions while diversifying our exposure.
We are, however, heading for a new period of adjustments to expectations, possibly accompanied by erratic market movements in the short term before the most likely scenario – less inflation and lower growth rates – eventually prevails.