Financial update from Brewin Dolphin - 24 June 2022

June 2022

The Weekly Round-up

Friday 24 June 2022

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, explores US inflation expectations and the economic fallout of the UK’s cost-of-living crisis

Markets stabilised and rebounded this week as sentiment reached extreme bearish levels, according to a technical measure by Bank of America. The increasing risk of a recession continues to dominate investors’ minds, which has led to a slump in commodity prices and a notable retreat in sovereign bond yields.

Brent crude oil prices continued to fall from a peak of $124 to a low of $108 this week and iron ore prices slumped by about 20% from a near-term high. Palm oil, the world’s most consumed edible oil, has fallen to its lowest level this year as top producer Indonesia ramps up exports, while wheat, corn and soybeans have tumbled from their highs. Global food costs have already fallen from their all-time peak in March, and more declines could follow.

US inflation expectations

The development is actually good news when it comes to curbing input prices and goods inflation, which is also the aim of the tighter monetary policy we are seeing. Market-based inflation expectations have come down this week as a result. Markets are betting that the US Federal Reserve may have to start cutting interest rates in Q2 2023 or at least dial back some hawkishness given weaker economic developments.

US ten-year government bond yields are down sharply from a peak of about 3.5% to just above 3.1% currently. Global equities, and in particular growth stocks which have been battered by the surge in bond yields year-to-date, staged a decent rebound this week.

Why are markets increasingly worried about the risk of a recession? The data coming out from major economies has been poor. In particular, US housing market data continues to disappoint. A series of data, including existing home sales and mortgage applications, suggest a slowing housing market is all but certain, with 30-year fixed mortgage rates reaching 6%. Monthly business surveys, including purchasing managers’ indices for services and manufacturing, slowed markedly in the US and in Europe. US initial jobless claims are slowly creeping up as well, albeit remaining very low. Federal Reserve chair Jerome Powell said at the semi-annual Senate testimony that a soft-landing is “very challenging” and reiterated his commitment to fighting inflation.

UK growth concerns

While the US economy is facing headwinds from higher gasoline prices, rapid hikes in interest rates and a slowing housing market, concerns about UK growth are on a bigger scale.

We have already seen two consecutive months of declining gross domestic product (GDP) growth and the second quarter looks certain to contract. The potential for a summer of industrial action is putting further strain on activity, especially for the hospitality and retail sector. Investors are getting more bearish on the UK, with a Bloomberg survey showing close to three quarters of respondents expect a recession within a year and the pound at risk of touching early pandemic lows.

This week’s data from the UK shows the extent of the fallout from the cost-of-living crisis. UK retail sales fell 0.5% in May, which is the third monthly contraction in four months. Food sales were the main driver

of the decline as consumers struggled with higher supermarket bills. Discretionary spending, such as household goods and at department stores, were down as well.

Meanwhile, the GfK consumer confidence index slumped to the lowest level since the survey began, reflecting extreme pessimism around personal finances and the broader economic outlook. This came despite the cost-of-living support announced by the government, suggesting households are not seeing meaningful help from these measures and are looking to tighten their belts in the coming months.

UK inflation hits 9.1%

Rampant inflation in the UK is making households very nervous. The UK headline annual inflation rate accelerated to 9.1% in May from 9% a month earlier. Food prices, which are rising at the fastest pace in 13 years, drove the bulk of the pickup in inflation in May. Matters will get worse later this year when another energy price cap hike kicks in, with the Bank of England forecasting that price gains will surge above 11% in October.

The silver lining is that underlying inflation excluding food and energy slowed to 5.9% from 6.2%, reflecting an easing in price increases from physical goods. Given the easing in core price pressures, the Bank of England is likely to stick with 25 basis point incremental increases in interest rates. Similar tothe US, markets are currently expecting rate cuts to happen in Q2 2023, so most of the pain in higher interest rates would likely be felt this year.

Markets remain vulnerable

With recession risks and inflation numbers under huge scrutiny, markets are likely to remain sensitive and vulnerable in the near term. That said, a lot of the bad news has been priced in and sentiment has turned very bearish.

Taking the US benchmark S&P 500 as an

example, the good news is the average decline that occurred during past recessions – which were primarily driven by monetary tightening – was similar in magnitude to the downside that has occurred so far this cycle. As such, even if we are heading for a recession, a lot of the bad news is arguably priced in to equity valuations.