Financial Update from Brewin Dolphin - 17 February 2023

February 2023

The Weekly Round-up

Friday 17 February 2023

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses the latest US inflation numbers, strong economic data, and the outlook for interest rates.

This has been an interesting and volatile week for markets, with an array of economic data and messages from Federal Reserve officials to digest.

The most noteworthy event was arguably the US inflation report on Tuesday, which proved to be higher than expected. Markets sailed through the initial volatility; after all, inflation is trending in the right direction. But during the week we got more evidence of a strong labour market (lower-than-expected initial jobless claims), more resilient consumers (a bumper retail sales figure in January) and more evidence that the disinflationary trend in US goods inflation is slowing (higher-than-expected US producer prices data). Throw in a couple of reactionary comments from hawkish Federal Reserve officials, and you get a cocktail of forces driving up government bond yields that challenged the year-to-date equity rally. In particular, the recent outperformance of growth stocks reversed towards the latter part of the week because of the surge in yields.

US inflation

Let’s start with US inflation numbers. In the grand scheme of things, inflation is slowing year-on-year (YoY) which is good news. The headline consumer price index (CPI) slowed from 6.5% to 6.4% YoY and core (ex food and energy) CPI moderated from 5.7% to 5.6% YoY. The problem is these readings are higher than economists’ expectations, and prices actually rose month-on-month (MoM). Shelter costs contributed to almost half of the increase in prices in January and its outsized weight in core CPI makes it the ‘elephant in the room’ to watch. On the positive side, there is evidence that rental costs are slowing down, according to the Zillow rent index. House prices in the US were in contraction for a couple of months and may weaken further. So there is reasonable confidence that the shelter component of US CPI will slow with a lag. That said, it takes time for that to play out in official statistics, and markets are notoriously impatient.

Putting shelter costs aside, economists are fixated on ‘super core’ inflation, which is core services excluding shelter. This is reportedly a key gauge for the Federal Reserve given that it is closely related to the state of the labour market. This measure of underlying inflation slowed in January. So far, there is no evidence of a wage-price spiral and, in fact, wage growth has been decelerating. That said, it is difficult to dismiss the strength of the labour market, so underlying inflation is likely to remain elevated for a bit longer.

Meanwhile, there is some concern that the sharp disinflationary trend in goods prices is moderating. There are a number of factors, including the softer US dollar, a rebound in used car auction prices and the latest monthly rise in US producer prices. On Thursday, the release of US producer prices caused some discomfort in markets. Headline producer prices rose by +0.7% MoM and the measure excluding food and energy rose by +0.5%. The YoY rate continued to slow but came in much higher than expected. This was driven by a recovery in energy prices at the start of the year. With China reopening, there is always a concern that the rebound in economic activity, in particular travelling, will boost oil prices at a time when oil supply remains tight. The renewed pickup in the US pipeline inflation measures highlights that the path to disinflation can be bumpy and will take time.

Good news is good news

So far this year, we have seen the ‘good news is good news’ narrative playing out. This makes sense as inflation is slowing and the Fed is nearing the peak of interest rate hikes. Good economic data suggests the probability of a ‘hard landing’ has reduced. Indeed, as the year turned, gross domestic product (GDP) growth forecasts in many major economies were revised higher due to lower gas prices in Europe, the reopening in China, and resilient labour markets. The idea of a ‘soft landing’ or ‘no landing’ has been gaining traction, therefore supporting risk assets year-to-date. That said, this week’s strong economic data has caused the markets to rethink the level of the peak federal funds rate, as well as how long policy rates will stay elevated. The better the economic data, the higher the chance that inflation stays above 2%, and the higher the likelihood that the Federal Reserve keeps policy at restrictive levels. This ultimately means a recession may be unavoidable but that the timing of it gets delayed. Towards the latter part of the week, the good news is bad news narrative has gained the upper hand.

So what good news have we seen? US retail sales rose +3.0% month-on-month with broad-based gains in various categories of sales. The US housing market remains a weak spot, but the latest homebuilder confidence survey suggests there are tentative signs of recovery. Initial jobless claims were better than expected last week, dipping below 200,000. All these point to a tight labour, good consumption, and a potentially strong US Q1 GDP figure – and therefore an economy that remains hot with lingering inflationary pressures.

Interest rates

On Thursday, Federal Reserve Bank of Cleveland president Loretta Mester said she had seen a “compelling economic case” for rolling out another 50 basis-point interest rate hike. St. Louis president James Bullard said he would not rule out supporting a 50 basis-point hike at the March meeting. While Mester and Bullard do not vote on monetary policy decisions this year, their comments suggest that concerns among Fed officials are brewing.

Traders have been upping their bets on how far the Fed will raise rates this tightening cycle. They now see the federal funds rate climbing past 5.25% in June – that compares with a perceived peak rate of 4.9% just two weeks ago. Markets are no longer pricing in rate cuts, compared to expectations of two rate cuts previously. US ten-year treasury yields re-touched 3.9% this week. Meanwhile, the yield curve (longer-dated government bond yields minus shorter-dated government bond yields) is the most negative (or inverted) since the 1980s. This suggests a US recession remains more likely than not. It is fair to say macroeconomic uncertainty remains very high this year, given the complexity of the path of inflation, geopolitical risks and lags from an aggressive rate hike cycle last year. We expect financial markets to remain very sensitive to any inflation, jobs data and Fed commentary in the near term. In short, we do not think the conditions for a sustainable equity rally are there yet.

UK economic data

What about the UK? Similar to the US, we saw resilience in economic data and, as such, traders have lifted their expectations on the path of the UK bank rate, though just modestly. The UK bank rate is expected to peak at around 4.5%, meaning there are potentially another two rate increases to come. Starting with the labour market, the UK unemployment rate remained at 3.7% in the three months to December and job gains were better than expected. The bit of discomfort lies on wage data, which showed a pickup in weekly earnings excluding bonuses from 6.5% to 6.7%. In particular, private sector wage growth was +7.3% YoY. Even though vacancies continued to slow, job openings were at just over one million and well above the pre-pandemic average.

In relation to that, UK retail sales expanded in January, defying expectations of a contraction. Economists were pessimistic on the numbers because of the widespread strikes in the UK, particularly train strikes which tend to affect spending in shops and restaurants. UK retail sales contracted for most of 2022, and whether 2023 marks the start of a positive trend remains doubtful. Although inflation has eased, household finances are likely to remain under pressure as wages fail to keep up with prices. Tax rises will further bite into people’s pockets. UK consumer confidence remains near record lows and a further weakening in the housing market may lead households to be more cautious. Taking a glass half full view, the recent resilience in jobs and retail sales data suggests that a recession (if any) is likely to be mild. The substantial fall in wholesale gas prices also suggests there is light at the end of tunnel for energy bills going forward.

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