Goldilocks in the US, but not in the UK
Goldilocks in the US, but not in the UK
Whilst wage inflation in the UK remains too high for the Bank of England, which may mean further interest rate increases, in the US and even Europe, there are signs that inflation pressure is easing.
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.
Falling inflation is good news for policymakers, but is a double-edged sword, as falling inflation may impact corporate revenue growth.
Slow revenue growth has been a feature of recent company updates, and analysts are reliant on a sharp recovery in profit margins to drive profits over the next year.
Inflation globally has peaked, and investors are now figuring out the path of economic growth rather than worrying about inflation as they were in 2022.
On reflection, in late 2022 the market had started to factor in some element of an economic recession. In the US, economic growth this year has been much more robust than predicted even though other regions (Europe and China) have reported poor economic growth. It appears that the UK has avoided a recession, even though economic growth remains lacklustre.
It now seems possible that the US economy could see a sustained fall in inflation without a rise in unemployment, the so-called Goldilocks outcome. However, having revised up their growth forecasts for 2023, economists (never the life and soul of a party) continue to be downbeat about growth in 2024.
How policymakers react to lower inflation may be key to market sentiment. Resilient economic growth may mean that the policymakers hold interest rates higher for longer and seek to unwind the policy stimulus enacted through Covid. One of these steps is to sell-off bonds that Central Banks bought (Quantitative Easing) to support the economy. This selling of bond holdings may be one reason that bond yields continue to move higher despite lower inflation.
UK inflation remains too high for comfort
Inflation has been the problem that has stalked markets and policymakers for the past two 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.
In the UK inflation and wages continue to be higher than expected or comfortable for policymakers. Headline inflation has fallen from its 2022 peak, but recent wage inflation is likely to result in increased consumer spending power in coming months.
Even though UK headline inflation has eased back, the surprise rise in wage inflation may extend the period of elevated inflationary pressure in the UK economy
Source: Bloomberg, Artorius
The contrast between the UK and other economies is shown up starkly when viewing the underlying inflation measure, which removes the volatile food and energy component from inflation.
Labour shortages caused by Brexit, increased levels of sickness as the NHS struggles, and older workers leaving the labour force, along with slower and less generous support on energy than some European neighbours has resulted in a widespread inflation problem. A sharp increase in wage inflation means that the Bank of England believes will result in higher inflation for longer. As a result, interest rates are expected to keep on rising throughout the remainder of 2023.
Core inflation (which excluded food and energy costs) remain much higher in the UK than in similar countries.
Source: Bloomberg, Artorius
US goldilocks scenario?
In the US, recent inflation data has been better than expected offering the prospect of much lower inflation in the months ahead. Whilst the focus of US policymakers has been on falling inflation, they will also take comfort of evidence that the pace of wage increases is moderating.
If wage inflation continues to ease back, then the Federal Reserve may choose not to raise interest rates much further, if at all.
US wage inflation is moderating which may enable US interest rates to be put on hold
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.
We are mindful that this would be an unusual outcome and some leading indicators of employment suggest that the US economy is slowing. Job openings are falling at around 20% since this time last year and growth rate in the number of hours worked has slowed from 3.5% (year-on-year) in January to just 1.3% in July. This is consistent with the moderation in other economic indicators, but the fall in job openings suggests that the US labour market and overall economy is cooling.
US job openings are falling and suggest that working hours may start to shrink in coming months
Source: Bloomberg, Artorius
Valuation risk and waiting for earnings
After the strong rally in markets in the first half of the year, equities have eased back in the past few weeks.
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.
It is notable that despite the better than expected economic outturn, analysts have cut their expectations for US profits for 2023 by about 4.5%.
The current earnings season that started in the second week in July, came in slightly ahead of expectations, largely in part to the ‘surprise’ from Amazon, which delivered very strong results.
The uptick in 2023 earnings expectations is shown in the chart on the right, but analysts remain cautious about upgrading 2024 numbers. Analysts are expecting profit margins to return to peak levels, which would be unusual at this stage of the economic cycle, but much about this economic cycle has been unusual.
We are wary of risk assets 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.
Earnings may have troughed, but expectations for 2024 remain stable
Source: Bloomberg, Artorius
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Goldilocks in the US, but not in the UK
With inflation pressures easing in the US without a rise in employment, it holds out a hope that a recession may be avoided, and the economy achieve a “soft-landing” despite the significant rise in interest rates.
The UK is an outlier with inflation running notably higher than the US and Europe, which means the Bank of England may keep rising interest rates this year as others pause.
Strong stock market performance reflects increased confidence in a “soft-landing” for the economy, but analysts are still cautious to upgrade earnings forecasts and are reliant on a sharp recovery in profit margins to drive profits over the next year.
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