The two main factors that drove global equities lower in May are no longer on investors’ minds: The US debt ceiling has been suspended until 2025, and investors appear to have stopped looking for the next weakest link among US regional banks. While there is no imminent risk of a technical default by the US or a systemic banking crisis, fixed income volatility is still high by historical standards.
Too early to celebrate
The agreement deal on the debt ceiling and the Fiscal Responsibility Act of 2023 suspending this borrowing cap until 2025 have removed the risk of US defaulting on its sizeable debt.
While an actual default always looked unlikely, it had been a major topic for market players in recent weeks. A favourable outcome from the negotiations between opposition Republicans and the administration should have led to a sustained rally in equities. However, the gains proved short-lived, suggesting that investors have their minds on other issues.
Among these, monetary policy developments in the coming months have regained prominence after the policy decisions of the Bank of Canada (BoC) and, to a lesser extent, the Reserve Bank of Australia (RBA). Both raised interest rates.
Rate hikes are not over
The RBA surprised markets by raising its policy rate by 25bp to 4.1% on 6 June and continued to signal that “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe”. The next day, the RBA governor said the decision followed reports of an upside risk to the inflation outlook.
On 7 June, the BoC raised its policy rate to 4.75%, taking the view that monetary policy was “not restrictive enough to restore the supply/demand balance and ensure a sustainable return to the 2% inflation target “. After increasing rates by a total 425bp since March 2022 – and pausing in March and April – markets had expected no action as core inflation decelerated from 5.4% year-on-year at the end of 2022 to 4.1% in April.
Fragile assumptions
Following the rapid rise in key rates since March 2022, investors envisaged slowing core inflation and US Federal Reserve (Fed) rhetoric becoming move dovish alongside a pause in the tightening cycle.
At the policy meeting on 2/3 May, the Fed raised (as expected) the federal funds target rate by 25bp to 5.00%-5.25%, taking its tightening to a cumulative 500bp since March 2022. The official comments that followed convinced investors that this was likely to be the last hike in the current cycle. The Fed’s communiqué no longer mentioned that ‘additional policy firming may be appropriate’ and in his press conference, Chair Jerome Powell emphasised that the Fed would make a meeting-by-meeting assessment of its policy stance.
With core inflation clearly having peaked and amid forecasts for a recession in the next 12 months, market expectations showed the Fed holding rates steady at the 14 June meeting, marking either the end of the tightening cycle or a pause before one final rate rise.
The decisions of the RBA and the BoC, another strong US employment report, and higher-than-expected inflation in the UK have spoiled this benign outlook.
Further surprises on job growth
The latest US job report far exceeded market expectations. Over 300 000 jobs were created in May, marking the 14th ‘positive surprise’ in a row. The persistent surprises show that economists are struggling to accurately assess developments in the US labour market.
Job openings increased in the latest month, indicating that demand is still outpacing supply. As a result, wage increases remain high at around 5% year-on-year for production and non-supervisory employees. The non-farm payrolls report included ‘negative’ surprises, however, such as the 0.25 percentage point increase in the unemployment rate to 3.7%, its highest since October. Weekly jobless claims (seasonally adjusted) have jumped to their highest level in two years. As has been the case for many months, the data do not tell a consistent story.
In contrast, growth in the eurozone has been less resilient than initially estimated. Germany entered into a technical recession after GDP contracted in Q1 by 0.3% after a 0.5% fall in Q4 2022, as did the eurozone, driven by a drop in private consumption (-0.3% in Q1 after -1.0% in Q4).
In its spring forecast, the European Commission stressed that ‘downside risks to the economic outlook have increased.’ Economic sentiment as measured by the commission fell in May to its lowest since the end of 2022.
At the same time, headline inflation dropped from 7.0% YoY to 6.1%. Core inflation at 5.3% is back to its January level. Goods prices (excluding volatile elements) have continued to ease; producer prices have confirmed this trend.
What is new is the slowdown in inflation in services. Transport prices in Germany may explain this trend, but there are also signs that this is in line with French data. Services inflation is a crucial indicator for the European Central Bank (ECB).
Wishes vs reality
The prospects of a recession resulting from monetary policy tightening are being debated hotly, not least because economic indicators have broadly been coming in stronger than expected. In our view, recessionary concerns are not reflected in the performance of the main equity indices.
Investors may wish for a slowdown in US growth and inflation, allowing for a ‘pivot’ in policy rates. But for now, investors face a still resilient US economy and the ECB saying it plans to continue raising its key rates.
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