Financial Update from Brewin Dolphin - 16 August 2024

August 2024

The Weekly Round-up

Friday 16 August 2024

In our latest weekly round-up, Guy Foster, Chief Strategist, discusses political developments in Japan and what these could mean for monetary policy, and U.S. and UK inflation data.

Japanese political drama

There were a lot of economic data and a few key earnings reports expected this week. What was unexpected, although not entirely surprising, was the announcement from Japanese Prime Minister Fumio Kishida that he won’t take part in the race to become party leader in September, effectively resigning the premiership.

Kishida has been dogged by scandal this year, but still had a relatively long tenure of nearly three years; his predecessor served just over a year as prime minister, which is not unusual.

Kishida’s replacement will be important. Currently, the most popular of his potential replacements is former Defence Minister Shigeru Ishiba. He has expressed a desire to see Japanese monetary policy normalised, in what seems like the most pronounced threat to the Japanese economic status quo.

Yields rose and the yen rallied upon Kishida’s announcement, possibly because of Ishiba’s stance. Nevertheless, the week saw strong performance from risk assets and Japanese equities.

That could be because this week revealed information that could support or refute the case against the U.S. economy. Is it plunging into recession, or is the consumer just taking a breather? Overall, the data was reassuring. This meant less pressure for sharp interest rate cuts in the UK and may even have rekindled the carry trade.

U.S. inflation

The U.S. consumer price index (CPI) was the most important monthly data for a long time, as inflation remained the main source of angst for investors. But weak price growth in May and June seemed to enable investors to channel their neuroses elsewhere.

Were they right to? Inflation’s certainly not the demon it was. Prices rose at 3% over the last 12 months – still too high, but well down on the 9% rate reached in June 2022.

At the same time, headline inflation hasn’t dropped much in the last year. In fact, one of the bright spots about this month’s report was that at 2.9%, it dropped to its lowest since June 2022, which saw it slow to 3%. Since then, inflation has been stubborn and is unlikely to fall much faster over the coming months.

An alternative perspective

Investors, however, have learnt to look beyond the headline CPI rate. The Federal Reserve (the “Fed”)’s preferred inflation gauge is the personal consumption expenditure price index (PCE), but CPI gets the headlines because it’s released earlier in the month.

In terms of the differences, CPI is increasingly becoming a reflection of increases in rental costs. For example, rent makes up 38% of the CPI basket and contributed 1.8% of the 2.9% rate.

Rental costs accelerated this month, which was very disappointing, but it’s not something to be worried about. We can say with enormous confidence that they’ll fall in the coming months, as the CPI basket, which includes one sixth of the rent revisions of the overall basket, lags the timelier all tenants rent index. The latter has been slowing rapidly and implies that the path of rental CPI normalisation has further to run.

To reflect the part of the economy that can actually be influenced by monetary policy, the Fed has placed more emphasis on a measure called ‘core services excluding rent’. This seems the most important number to take away from CPI, as it will influence how the Fed considers changing interest rates. When core services ex rent declined in May and June, it suggested that inflationary pressures had finally been tamed. But having stripped out many of the volatile prices, what’s left really ought to be quite a stable number, so two months of declines seemed unsustainable.

This month these prices rose by 0.21%, which would be consistent with a 2.5% annual rate. 2.5% CPI is only just above the equivalent 2% rate for PCE, so things are definitely moving in the right direction. These CPI numbers would not dissuade the Fed from cutting interest rates in September.

The only warning sign for policymakers here would be the persistence of alternative measures of CPI. Measuring price increases without the most volatile elements can be done by excluding food and energy (to give core CPI), or it can be done by literally excluding the most volatile elements, no matter what they are (the trimmed mean CPI) or by only measuring the median price increase each month.

Another alternative perspective

These approaches show that inflation is slowing, but remains above the headline rate of inflation, and the most recent month actually saw prices increase. And that belies the true message of this week’s CPI report: that inflation remains above target, but not far enough above target to prevent the Federal Reserve from cutting interest rates when it meets in September.

The Fed believes rates are restrictive at the moment and can see a change in consumer behaviour, so it has become very concerned about the economy being too weak, and less concerned about inflation being too hot. Expectations that rates might be cut twice look wide of the mark though.

The UK economic recovery continues

We also had the UK inflation report this week. It was biased by some volatile numbers, but again, the alternate measures of CPI, for example the median CPI, show that inflation hasn’t normalised yet.

Earlier in the week, it did seem as if there’s a reducing number of vacancies, but an apparent reduction in payrolled employees a few months ago has turned out to be a misestimate, which has been corrected by revisions.

The employment data are acknowledged as being unreliable due to low response rates to surveys. Fundamentally, it seems unlikely that the labour market is particularly weak because the economy has been picking up speed. Retail sales announced this morning reflected this, and the slowdown in inflation the UK has experienced so far, coupled with increases to the National Living Wage and the cut in National Insurance, have been a wind in consumers’ sails.

Flipping back to U.S. retail sales, these were more upbeat than anticipated. We’ve heard a downbeat story from many retailers during earnings season, and this broadly continued with Home Depot confirming customers have spent more on wares to spruce their homes up over those required to perform major renovations.

Walmart saw similar focus on value from customers. It’s difficult to square with the official retail sales numbers. Perhaps the message that some retailers have seen things pick up a little at the start of August is the most telling.

What’s next?

The Democratic National Convention will take place Monday to Thursday next week. Tim Walz will speak on Wednesday, while Vice President Kamala Harris will speak on Thursday. Nex week will also see the publication of meeting minutes from the European Central Bank (ECB) and the Fed, as well as provisional purchasing managers indices for August.

Fed Chair Jay Powell and Governor of the Bank of England Andrew Bailey will both speak at the Kansas City Fed’s Jackson Hole Economic Symposium, which takes place between 22 and 24 August. The symposium features keynote speeches from prominent economists and policymakers. These speeches often provide insight into the Fed’s monetary policy thinking and can move financial markets.

For example, in 1996, then Fed Chair Alan Greenspan warned about the dangers of “irrational exuberance” in the stock market. The speech was seen as a warning sign for the dot-com bubble, and the Dow Jones Industrial Average fell 2.3% the next day.

In 2013, former Fed Chair Ben Bernanke hinted at the possibility of tapering the Fed’s quantitative easing programme and sparked a global market sell-off, with the S&P 500 falling 1.4% and the ten-year Treasury yield rising ten basis points (considered a lot at the time).

One of the most famous was the pledge of then ECB President Mario Draghi to do “whatever it takes” to preserve the euro. The speech helped calm market fears about the European sovereign debt crisis, and the euro rose 1.5% against the U.S. dollar.

So, plenty of moments that will live on in market folklore have emanated from the Jackson Hole Symposium. Many of the great and good will be there, but Bank of Japan Governor Kazuo Ueda has a prior engagement and will instead attend a special session at Japan’s parliament to discuss the 31 July rate hike. This took the market by surprise and was seen as a significant contributor to the sharp sell-off in Japanese equities that took place thereafter. It will be a busy week for him.

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