Global central banks have been tightening policy aggressively to slow decades-high inflation, sparking concerns of an impending economic recession. While the latest US inflation data showed a modest deceleration, inflation is still far too high for central banks to pause their planned hikes. Therefore, risk assets look likely to be buffeted by policy headwinds, at least in the short term.
The US has had a technical recession – defined as two consecutive quarters of negative growth – but overall macroeconomic conditions are still strong. The robust labour market in particular has ensured that investors still expect the Federal Reserve to keep tightening for the rest of this year.
US consumer price inflation rose by 8.5% YoY in July, less than the 9.1% jump in June that prompted the Fed to raise interest rates by a sizeable 75bp just two weeks ago. The core CPI rate remained high at 5.9% YoY.
The Fed’s preferred measure, PCE inflation, had risen by 6.8% YoY in June, marking its fastest pace since 1981. Core PCE inflation edged up to 4.8% from 4.6% in May, more than double the Fed’s 2% target rate.
At the same time, US labour market conditions have remained tight, with July non-farm payroll employment rising by 528 000, or by more than twice the market’s expectation, and average hourly earnings increasing by a strong 0.5% MoM. Total civilian hourly compensation rose by 5.1% YoY in Q2, marking the fastest gain since 1990. The Atlanta Fed’s Wage Growth Tracker shows average hourly wages have risen by 7.5% in the past 12 months.
For the Fed, its dual mandate – steady inflation and full employment – is under threat. Inflation is expected to remain above target for a while. Employment is more than full, with wage demands responding to three years of above-target inflation.
Some weakness has nonetheless emerged, not surprisingly prompting recession concerns amid the Fed’s aggressive tightening. The advanced estimate showed that US GDP fell by an annualised 0.9% in Q2 2022, after falling by 1.6% in Q1. There was broad-based weakness in consumption, residential and non-residential investment, inventories, and government spending.
Initial jobless claims have trended higher, but not yet to worrying levels. To cut costs and prepare for a possible recession, businesses across sectors from consumer discretionary to automotive have been laying off staff and introduced hiring freezes. Job worries have contributed to a fall in consumer sentiment – by 2.7ppt MoM to 95.7 in July, below the 97.0 consensus expectation.
The July services Purchasing Managers Index (PMI), a measure of business activity in the services sector, fell to 47 (indicating contraction) from 52.7 in June. The more exhaustive services ISM measure, however, remained in expansion territory. The Philadelphia Fed’s July regional survey on manufacturing weakened noticeably. New home sales dropped by 8.1% YoY in June after a cumulative 11% drop in April and May, reacting to the jump in mortgage rates.
The shock from the Ukraine war has upended supplies and fired up inflation, prompting both the ECB and the Bank of England to raise rates by 50bp recently.
Eurozone CPI inflation hit another record in July at 8.9% YoY, driven by food and core goods inflation. The 0.3 ppt jump in core CPI inflation was a sign of broadening inflationary pressures.
The ECB’s rate rise was the first in 11 years. The bank argued that this was a front-loaded move that would allow it to transition to a ‘meeting-by-meeting’ approach on policy rates. The BoE reiterated it was ready to act ‘forcefully if necessary’ by continuing to raise rates if inflationary pressures persisted, despite a recession.
While eurozone GDP growth was stronger-than-expected at 2.8% annualised in Q2 thanks to the lifting of Covid-related restrictions, high-frequency data still indicated some weakness.
European Commission data showed consumer and business confidence dropping to record lows after the onset of the conflict in Ukraine. The German Ifo index fell to a 25-year low in July over fears that a disruption in gas supplies will weigh on the economy.
The market expects the ECB to continue tightening into 2023, although at a more moderate pace than in July.
China’s economic slowdown is spilling over to major economies such as Germany and South Korea. The countries have historically run trade surpluses with China, but have recently seen unusual deficits (see Exhibit 1).
China’s role as the world’s largest commodity importer tends to overshadow the fact that it also imports many manufactured and capital goods for both local consumption and processing. Fewer imports by China are aggravating the market’s concern over a global recession via trade channels.
Recession fears nonetheless do not appear to be deterring the major central banks’ anti-inflation resolve. In our view, bond markets have pivoted away from inflation towards growth concerns prematurely. The Fed and the ECB will need convincing evidence that inflation is reverting to target before they change their stance. Such evidence might include a series of declining monthly inflation data and easing labour market conditions.
Fed Chair Powell has been open in arguing that the risk of persistent inflation is greater than that of a recession. He has said that ‘growth and the labour market do need to slow’. Hence, the slowdown may decelerate the pace of policy tightening, but not stop or reverse it anytime soon.
In this context, we continue to favour commodities. With prices across 80% of the commodity complex down by more than 20% since the recent peak, we see an attractive valuation opportunity to add to our tactical exposure. We believe commodities should still benefit from fundamental support.
We have upgraded European investment-grade credit to ‘favour’ as distress in this segment is now pronounced and the valuation opportunity looks increasingly attractive.
European IG appears to be pricing in an 8-10% implied default rate, which is twice the worst rate over the last five years and eight times the historical average. That looks too gloomy to us given the shallow 2001-style correction we expect and the fact that corporate finances are broadly healthy.