Better than feared
Better than
feared
The inflation backdrop has improved markedly in the past few months and, whilst growth has slowed, there has been greater resilience than expected.
Even though inflation is falling, it remains too high for the comfort of policymakers, so it is likely that interest rates will continue to be raised in coming months especially in the UK. The impact on the economy may be slower than in previous economic cycles, but the brake is still being pressed by policymakers and an acceleration of activity is unlikely in the near term.
Corporate analysts appear more optimistic about profitability. Estimates around companies’ profits have stabilised and are showing signs of recovery in Europe. The ongoing company reporting season will provide clues to the potential impact of the uncertain economic backdrop for company profits.
Better inflation
Inflation has been the problem that has stalked markets and policymakers for the past few years. Policy put in place through the Covid pandemic resulted in excess demand at a time of supply chain chaos, which was then followed by an energy price shock because of the Russian invasion of Ukraine in Spring 2022.
Whilst commentators find it easy to criticise the failure to control inflation, policymakers confronted unconventional economic shocks with conventional economic policy. The policy is working, albeit has taken longer to bring inflation under control than forecast, especially in the UK.
UK inflation remains much higher than comparable countries.
Source: Bloomberg, Artorius
In the US, recent inflation data has been better than expected offering the prospect of much lower inflation in the months ahead. As a result the Federal Reserve chose not to raise interest rates in June. Investors are factoring in one more rate increase in the next few months, so if inflation continues to come in lower than expected then the Federal Reserve may opt to put further policy tightening on hold.
Whilst the focus of US policymakers has been on falling inflation, they will also take comfort in evidence that the pace of wage increases is moderating.
US wage inflation is moderating without unemployment picking up.
Source: Bloomberg, Artorius
That wage inflation is moderating without a rise in unemployment, could be a sign that the US economy is heading for a soft-landing, that is, a pause in economic growth without a recession. This could then be followed by a reacceleration in growth if inflation pressures ease in 2024 leading to cuts in interest rates.
We are mindful that this would be an unusual outcome and some leading indicators of employment remain suggestive of a rise in unemployment over the next year.
In the UK, alas inflation and wages continue to be higher than expected or comfortable for policymakers. The policy choice not to place a cap on energy prices early in 2022, as they did in France, has resulted in a widespread inflation problem, which has resulted in wage inflation that the Bank of England believes will result in higher inflation for longer. As a result, interest rates are expected to keep on rising through 2023.
Look on the bright side for 2024, if inflation does fall in the UK to around 4-5% from current levels, the present rate of earnings growth for the UK worker would translate into a real terms pay increase. But that may be a 2024 story to mull over during the next few months as interest rates rise and consumers continue to struggle.
Wage and price inflation too hot to handle in the UK which will result in higher interest rates.
Source: Bloomberg, Artorius
Goods and services
We have been cautious on risk assets over the past twelve months, as we expected the impact of interest rate increases to cut deeper than appears to have been the case. Whilst activity in some sectors has showed signs of a slowdown, other sectors appear to be weathering the interest rate storm.
The clearest indicator of this is the difference between the goods and services sectors in the US, as captured by the Institute of Supply Management (ISM) surveys. The ISM Manufacturing survey does reflect the ongoing recession in manufacturing sectors in the US economy. This also shows up in the retail sales data, which shows that in inflation adjusted terms the US consumer is spending less in 2023 than in 2022.
The ISM Non-Manufacturing (or Services) survey shows that non-manufacturing sectors are still growing. This would chime with the upbeat reports from airlines and cruise companies that reflect robust spending by the US consumer.
The ISM surveys reflect different rates of growth for the manufacturing sector (recession) and service sector (still growing) in the US economy.
Source: Bloomberg, Artorius
As the services sector became an increasingly larger share of the economy, from less than half in the 1950s to over 70% now in both value added and employment, there have been several instances where a contraction in the manufacturing sector did not eventually lead to a recession. The most recent episodes were the energy slowdown in 2015/16 and the trade-war induced manufacturing slump in 2019.
Interestingly, in both instances the Federal Reserve turned dovish – the Fed paused for a year in its hiking cycle in 2016 and started cutting rates in the summer of 2019.
Some services activities such as transport and logistics have signalled that they are suffering from the negative development in manufacturing. In previous cycles, the services sector has softened after the weakness in manufacturing, but with the resilience in the labour market it could take much longer than in the past for the services sector to feel the effects of monetary policy tightening.
In addition, the US household sector has yet to fully spend the excess savings generated as a result of fiscal handouts through the pandemic. These remaining savings appear to be skewed towards households with higher incomes, which may explain weak retail sales on the high street and a rise in credit card delinquencies but better spending in more upmarket activities such as tourism.
Valuation risk and waiting for earnings
After the strong rally in markets in the first half of the year, led by the technology giants and excitement around Artificial Intelligence, equity markets have become fully valued in our eyes, especially in the US.
Whilst the news-flow has been better than expected on both economic growth and inflation, the market may have got ahead of itself in terms of pricing in a recovery in earnings.
The current earnings season, that started in the second week in July, may tell us more about the mindset of the US corporate in the face of elevated interest rates and mixed economic growth.
We are wary in the face of high interest rates, which will make corporate investment more expensive to finance, alongside a backdrop in which banks are indicating that they are cutting back on lending.
*Any feedback provided can be anonymous
On balance better than feared
Whilst interest rates will rise further in the UK, in the US and even in Europe there are signs that inflation pressure is easing. However, the brake is still being pressed and an acceleration of economic growth is unlikely in the near term.
Whilst wage inflation in the UK remains too high for the Bank of England, in the US wage inflation has eased markedly as the labour market has cooled. This cooling has yet to result in a rise in unemployment which holds out hope that a recession may be avoided.
In the US, there are mixed messages about the state of economic growth. Retail sales and industrial production continue to fall, which signal recessionary conditions, but the service sector remains resilient.
Falling inflation is good news for policymakers, but is a double-edged sword, as falling inflation may impact corporate revenue growth.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 21st July 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
Nothing in this document is intended to be, or should be construed as, regulated advice. Reliance should not be placed on the information contained within this document when taking individual investment or strategic decisions.
Any advisory services we provide will be subject to a formal Engagement Letter signed by both parties. Any Investment Management services we provide will be subject to a formal Investment Management Agreement, which will include an agreed mandate.
Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
FP20230721001