Financial Update from Brewin Dolphin - 12 May 2023

May 2023

The Weekly Round-up

Friday 12 May 2023

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses the Bank of England’s 12th consecutive interest rate rise, the latest inflation picture from the US, and data from China.

The UK

After a long weekend of celebrations for the coronation, the main news is firmly back on domestic monetary policy and economic issues. The Bank of England raised its Bank Rate by 25 basis points to 4.5% this week, with a vote split of 7-2. The rate hike itself was well-anticipated and priced in, so what mattered were the forward guidance and the accompanying quarterly macroeconomic projections. It was status quo for the former but jaw-dropping for the latter.

The forward guidance was unchanged in May, which means the Bank of England is not signalling a pause as some might have hoped. It continued to guide that “if there were to be evidence of more persistent inflation pressure then further tightening in monetary policy will be required.” The BoE has little choice but to leave the door open for further rate increases given inflation is double that in the US and above the pace in the eurozone. As with other major central banks, the BoE emphasised the need to be data dependent, given the uncertainty on the path of inflation.

There have been a few headline-grabbing changes to the BoE’s macroeconomic projections – and they are positive instead of gloomy for a change! The BoE judges that UK GDP growth over much of the forecast period will be materially stronger than in February’s forecasts. It once forecasted the UK would experience a prolonged recession, but a recession is no longer on the table. This is because of the ongoing strength in the labour market, the fall in energy prices, more resilient global growth than expected and support measures from the spring budget.

The BoE expects inflation to slow to 5.1% by the end of 2023, higher than the 3.9% forecast in February 2023. That shows it judges inflation to likely be more persistent, due to the tight labour market for instance. That means the prime minister’s pledge to halve inflation this year will be just met.

The combination of upward revisions to inflation forecasts and the improved growth outlook is hawkish for monetary policy. Traders continue to think the BoE is not done yet, with close to two more rate hikes by the end of the year being priced in.

Whether this should be the last BoE hike is debatable. While inflation remains high for now, it will slow sharply in the April release due to energy prices. While CPI at 5.1% by the end of 2023 is of course still too high, it is forecast to come back to the 2% target within two years. Other arguments for this to be the peak include the accumulated impact of rate rises, the UK’s greater interest rate sensitivity and the UK’s economic prospects remaining the weakest among key economies.

It is helpful to see the BoE has dedicated a section on the cashflow effects of higher interest rates in its May monetary policy report. It gives us an idea of the Bank’s thinking on the lagged impact of cumulative rate rises and therefore a glimpse into when it may stop hiking rates.

The Bank acknowledges that many mortgage holders have yet to experience higher rates. Although the rates being quoted on new mortgages have risen by around 300 basis points, the average effective rate on the existing stock of mortgages has only risen by 70 basis points, as 85% of outstanding mortgages are on fixed terms. The BoE’s analysis shows interest rate increases have had only a small effect on spending so far, which largely reflects lower spending by households with variable rate mortgages. But alarmingly, the cashflow effects from higher rates are expected to increase notably between Q2 2023 and the end of the year as more households re-mortgage onto higher rates.

Aside from the increasing impact on mortgage holders, the BoE also noted that the labour market, while still tight, is already loosening up somewhat. Surveys also indicate that some firms are responding to higher interest rates by cutting back on investment and reducing employment.

While the BoE may pause or push ahead with one or two more rate increases, depending on incoming data, it is fair to say the BoE is getting close to the end of its tightening cycle.

The US

Across the Atlantic, things look just a little easier for the Federal Reserve thanks to the ongoing slowdown in price pressures. US headline inflation slowed to 4.9% from 5.0% and came below estimates in April. Core inflation (excluding food and energy) slowed as expected to 5.5% from 5.6%, which means underlying price pressures remain sticky. The best news is perhaps the slowdown in “supercore” inflation, which covers services excluding energy and housing costs and is the measure that the Fed and markets care a lot about. It has moderated from 5.8% to 5.1% YoY and the month-on-month increase was just 0.1% (down from +0.4% in March) – the smallest increase since July 2022.

Rents inflation within shelter CPI continued to pick up, but it’s widely expected to reverse at some point given the slowdown in the timelier Zillow rent index. Other positive reads include dairy prices dropping by their most in six years and appliance prices falling by the most ever month-on-month in April.

The data supports a pause in interest rate increases in June as inflation is heading in the right direction and some key measures are cooling in relative terms. US equity markets rallied this week on expectation of a Fed pivot due to slowing inflation, while other data continued to hold up. But does the data support rate cuts later this year? That’s more debatable given how high both core and supercore inflation remained in absolute terms. Markets are currently pricing in three rate cuts by the end of the year. We think the path back to 2% inflation remains bumpy and the Fed will err on the side of caution.

China

China is supposedly a bright spot for the global economy this year. However, markets started to raise concerns about the sustainability and extent of Chinese growth after weak import and credit data. Are those concerns fair? We have tounderstand the recovery driver is quite different this time compared to previous cycles. The recovery in China so far has been uneven, and has mainly been driven by consumer spending (rightly so), rather than infrastructure and property investment. That did not stimulate demand for commodities such as crude oil and copper as much as hoped.

Just as when developed economies emerged from lockdown, people in China have switched from spending on goods to spending on services. For instance, domestic travel data has been very robust during May Golden Week and restaurant bookings have been very strong. It will be the domestic services sector that benefits from pent-up demand, which may not be reflected in the import data. This is something that makes it harder for the rest of the world to benefit from compared to previous cycles. The rebalancing act of growth drivers from a fixed investment / infrastructure binge to consumption (and toward self-sufficiency) is the aspiration of the Chinese authorities and such a trend is in the right direction.

China has been resisting putting more stimulus into the economy despite low inflation. This means there has been no liquidity boost, which is disappointing for investors. With an economy expected to grow by nearly 6% in 2023, it is fair to say that China is staying prudent on its monetary policy as pent-up demand is working its way into the economy.

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