Financial Update from Brewin Dolphin - 24 March 2023

March 2023

The Weekly Round-up

Friday 24 March 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the latest data on the manufacturing and services sectors, and ongoing stresses in the banking sector.

Two systems are increasingly in evidence in the world at the moment. They are independent but connected. One is the real economy of consumers and businesses transacting in goods and services; the other is the financial economy transacting in loans and deposits.

The financial economy only exists to serve the real economy, even if there is a valid debate to be had over whether economies have become over financialised.

The real economy, though, remains in pretty good shape. Indeed, there are some signs of it strengthening, although these are not conclusive.

Business surveys – a tale of two systems

This morning, for example, saw the release of provisional business survey data for many regions and that, funnily enough, was also a tale of two systems. The latest data on manufacturing, for example, was generally downbeat, implying that the sector is seeing a contraction. The cause was blamed on subdued demand. This would seem to add fuel to the suggestion that the economy is facing down a recession. That a recession is coming is a certainty; when is it coming is the question.

We have long felt that the point at which two-year yields rise above ten-year yields is a pretty reliable indicator that a recession is coming, even if it too is vague on the timing. The end of 2023 seems most likely using historical lags as a guide. The manufacturing sector might suggest it is coming sooner.

However, manufacturing is a relatively small sector of the economy compared to services, which saw a general acceleration of activity during February. We should recall that rebalancing of demand away from goods and towards services was expected as a response to the saturating goods demand which took place during lockdown. While we might have expected that to have run its course, it is not surprising to get a few aftershocks as manufacturers adjust their inventories.

The service sector does indeed appear to be gathering steam and, being so much larger than the manufacturing sector, it is difficult not to take our cue from it. Business services showed a broad improvement in services activity and, in the UK, retail sales data showed a substantially larger expansion than had been expected. This was the first consecutive two months of retail sales expansion since April 2021. It likely reflected the fact that consumers are beginning to get over the shock of a year of high inflation. Generally, consumer sentiment, whilst currently being very depressed, is improving, and measures of consumers’ expectations are rising markedly.

UK inflation

Perhaps the most concerning economic data was UK inflation, which unexpectedly saw a rise in the year-on-year rate. Although some of the increases could be traced to quite volatile components, the traditional mechanism of stripping out food and energy prices to get core inflation offered no comfort. Core inflation rose by the largest amount, on a monthly basis, since April 1991 (which saw increases in VAT and fuel duty).

It would have seemed cavalier to not increase interest rates in the face of apparent inflationary pressure, and in advance of strong retail sales. So the Bank of England’s Monetary Policy Committee showed resolve and raised rates by 0.25%, as the US Federal Reserve had done under similar circumstances on Wednesday.

Banking stresses

The case for not raising rates centred around the financial stress that continues to emanate from the banking system. It is argued that this causes a de facto tightening of monetary policy, and also that tightening monetary policy could intensify financial stress. As ever in finance, without being able to conduct a controlled experiment, we shall never know. However, the particular challenge for some US regional banks, and the one which put an end to Silicon Valley Bank, was the losses on long-dated bond holdings. It would be logical to fear that rising interest rates might intensify this risk, but while interest rates have been going up the prices of those long-dated bonds have been rallying a lot. Would they have rallied more if rates had been held flat? Possibly, but it is far from certain. Any indication that the Federal Reserve wavers in its conviction to address high inflation could put more pressure on long-dated bonds.

Perhaps a less discussed but greater concern would be that monetary policy moves so far are not being translated into higher borrowing costs for mortgage borrowers or corporate borrowers. Because bond yields have fallen over the last week, and by over a full percentage point over the last few months, financial conditions have arguably loosened. Taken in the context of cheaper gasoline prices too, there is a substantial boost coming to the consumer sector.

Silicon Valley Bank’s problems do not match perfectly to banking stresses in Europe, where Credit Suisse was forced into the arms of UBS last weekend. This has not served as a firebreak for the rest of the sector, which remains under pressure despite strong capital and liquidity positions.

Where Credit Suisse had been the target last week, so Deutsche Bank finds itself in the cross hairs this week. Trying to rationalise concerns about Deutsche Bank, the financial press found analysts pondering whether it reflected broader recession risks or more specific issues related to US commercial real estate and derivatives exposure. However, these factors have been well analysed and don’t seem sufficient to explain the weakness, which possibly stems from general nervousness in a market which is undergoing quantitative easing and where banks began the year as a very popular long position for asset managers.

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