WeekWatch – ‘Markets are still having a tough time figuring out which economic outlook to believe.’ March 23
Soft landing, hard landing, or no landing at all. Markets are still having a tough time figuring out which economic outlook to believe.
A soft landing is the scenario policymakers and markets would most like to see, where inflation is brought down without creating a recession. Worst case scenario is a hard landing, where rising interest rates push economies into recession. No landing would see economies continue to grow and inflation stay high.
Nobody knows, and increasing uncertainty saw global equities fall 2.5% in February, halting the progress made by markets since October and a sharp contrast to the 7.0% gain seen in January. The optimism that had driven shares up and global bond yields down has ebbed as data during the month suggested economies and labour markets are not feeling too much strain from high inflation.
European equities have significantly outperformed US equities since October last year, and it was the only region to post positive returns in February, climbing 1.6% on the back of strong consumer consumption figures and signs of slowing inflation.
But those hopes faltered as the new month began with figures showing European inflation remaining stubbornly high. Consumer price inflation eased to 8.5% in February, a barely noticeable change on the previous month and above the consensus forecast of 8.2%. The news fuelled expectations that the European Central Bank (ECB) will hike interest rates by another 50 basis points later this month.
However, on Friday investors were encouraged by news of continued recovery in eurozone business activity, particularly in the dominant services industry. It provided the latest sign suggesting that the region will avoid a recession, but also that the ECB will be emboldened into more aggressive monetary policy tightening. Another 0.5% increase in the ECB’s deposit rate this month is seen as a done deal by economists.
The more sobering rate outlook has seen government bond yields at their highest for years. Bond yields rise as prices fall. Two-year German bond yields hit their highest level since October 2008, while two-year UK gilts saw their biggest February rise since 2005. The two-year US Treasury yield also approached decade highs.
Losses for US equities in February mirrored those for global markets, but Wall Street ended another volatile week in positive territory, boosted by news that the US services sector grew at a steady rate last month.
Investors interpreted the data as signalling healthy growth with slowing prices, adding to hopes that the economy – and corporate profits – can withstand a higher-for-longer interest rate path. The publication of the latest US employment data on Friday will be a key indicator of the economy’s strength and the likely next move of the Federal Reserve.
Asian markets declined nearly 6% in February but bounced off a two-month low to record their best day in seven weeks on Wednesday, as data showed Chinese manufacturing activity had expanded at its fastest pace in over a decade.
The better-than-expected performance reflects the surge in activity following the easing of the country’s zero-COVID policy (ZCP) and added to speculation over whether China’s recovery will boost the rest of the world by raising growth or cause a resurge in inflation.
David Rees, Senior Emerging Markets Economist at Schroders, doesn’t believe China’s re-opening will benefit the global economy much, if at all. “China’s services sector was most hampered by ZCP and is likely to experience the same release of pent-up consumer demand. However, unlike other economies – certainly developed markets – Chinese households are not sitting on a huge stock of savings that can fund a prolonged period of rampant consumption.”
Schroders expects above-trend growth in 2023, but that the “sugar high” recovery will fade into 2024 as pent-up demand is exhausted. Rees believes the recovery will be skewed towards services, not manufacturing. “Prior strong investment and soft external demand means the recovery is unlikely to spur a renewed investment cycle in manufacturing that sucks in imports from Europe and the rest of the world,” he says.
UK stocks ended the week showing marginal gains. House prices saw their biggest annual fall in over a decade in the year to February, according to Nationwide. The building society suggested that the economic headwinds of a weakening labour market and higher borrowing costs would make it hard for the market to regain momentum in the near term.
The challenge for borrowers was underlined by comments on Wednesday by Bank of England governor, Andrew Bailey, suggesting that interest rates may need to go up again to slow down the cost of living. “I would caution against suggesting either that we are done with increasing the Bank Rate, or that we will inevitably need to do more,” he said.
Schroders is a fund manager for St James’s Place.
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