Financial update from Brewin Dolphin - 25 August 2023

August 2023

The Weekly Round-up

Friday 25 August 2023

In her weekly round-up, Janet Mui, Head of Market Analysis, discusses the impact of weak European economic data on interest rates, and the latest changes to Chinese policy.

The outlook for interest rates remains a big focus this week, as central bankers gather in Jackson Hole to discuss monetary policy. The markets are increasingly coming to terms with interest rates staying higher for longer.

US ten-year bond yields have reached the highest level since 2007 and real yields surpassed 2% for the first time since 2009. Central bankers are pretty much in data dependent mode now – but beyond the near term, the question is whether economies are prone to bouts of higher inflation given supply constraints such as labour shortages.

These longer-term dynamics can influence central banks’ assessments of the level of the neutral rate – the equilibrium interest rate at which the economy can grow without generating excess inflation pressure.

As the Federal Reserve eventually reaches the end of the hiking cycle, and as economists debate on the timing of the first rate cut, there will be more focus on the neutral rate. This will have important implications for the level of longer-term bond yields and, hence, valuations of risk assets.

Over the past month, yields have risen much more in longer-term maturity US Treasuries compared to the short end of the curve. Equities, particularly high-growth tech stocks, struggled against the backdrop.

Fed Chair Jay Powell’s speech in Jackson Hole was highly anticipated. Overall, the expectation was that the narrative will remain on data dependency but also erring on the cautious side on inflation. There was no big surprise in his speech.

Powell said the Fed is prepared to raise interest rates further if needed and keep borrowing costs high until inflation is on a convincing path toward its 2% target.

He added that the Fed intends to hold policy at a restrictive level until it is confident inflation is moving sustainably down to the 2% target. This has been the Fed’s narrative and forward guidance. In other words, policy direction depends on incoming inflation data.

In addition to Jay Powell, the central bankers who have spoken so far have leaned on the hawkish side, based on the premise that core inflation remains above target, the labour market remains strong and that further rate increases may be necessary.

Economic data in Europe

Admittedly, the latest economic data has taken a weaker turn, particularly in Europe. The latest readings of Purchasing Manager Indices (PMI) signal recession risks in Europe and the UK. The disappointment is that the services sector, which has been a resilient part of the economy, has fallen into contraction territory as the manufacturing sector has remained in a downturn.

We have previously highlighted the divergence between services PMI and manufacturing PMI and mentioned that historically, it is hard for them not to converge at some point. So, the answer is that the services sector is unable to hold up anymore. Interestingly, the data is taken as “bad news is good news”. This is because there is evidence that higher interest rates are dampening growth and inflation.

The markets believe the economic weakness will prompt the Bank of England and the European Central Bank to think twice on tightening monetary policy further. Bond yields did retreat modestly from the cyclical peak of 4.34% reached on 21 August. However, the cloud of policy uncertainty is going to linger.

The challenge could be particularly difficult for the Bank of England. UK inflation remains the highest of major developed economies and there are also increasing signs of weakness in the housing market and corporate sector.

Property portal Rightmove said its index tracking the cost of homes coming to market fell 1.9% in August. Rightmove tracks asking prices, and this suggests home sellers are waking up to the reality of a worsening market climate. It is one of the more leading indicators of home price trends as official transaction data often lags by several months.

On 22 August, the Bank of England published its analysis on how higher interest rates are putting pressure on indebted UK corporates through higher debt servicing costs. The Bank says the proportion of firms with a low interest coverage ratio (calculated by dividing a company’s earnings before tax and interest by their interest expense) is projected to increase from 45% in 2022 to 50% by the end of 2023.

Although the current level of vulnerabilities is below that during the financial crisis, it is a warning that if interest rates were to rise further, more businesses would struggle to service their debt.

We noted that the sentiment in the corporate sector is worse than the consumer sector. Over three-quarters of bank lending to UK businesses is at a floating rate, whereas most households are protected by varying lengths of fixed rate mortgages.

The latest UK GfK consumer confidence index improved (or turned less negative) in August, as the labour market has remained resilient so far and inflation has come down. Consumers also feel less negatively about future personal finances and the economic climate. Importantly, inflation expectations continued to trend lower, lowering the prospect of the high inflation mindset being anchored.

As the UK services PMI dipped into contraction in August, market expectations for peak UK interest rates have come down from 6% to around 5.8%, still implying at least two more rate increases from here.

Chinese policy

Over the course of the week, China risks remain at

the forefront, but again pessimism is rather contained within Chinese assets. The big news from a policy perspective is that China’s one-year loan prime rate was cut by only 10 basis point, and the five-year loan prime rate (the reference rate for mortgages) was left unchanged, despite a 15 basis point cut in the medium-term lending facility rate last week.

It suggests there is little appetite to let monetary policy go too loose, particularly regarding the struggling property sector. The authorities likely hold the view that reductions in mortgage rates may not be effective in supporting the sector given its oversupply problem.

If job security is lower and expectations for house price gain is negative, people will not be piling back in. This has left markets disappointed.

On Friday, Chinese authorities announced further easing in mortgage rules to support demand. People who have fully repaid their mortgages were previously subject to downpayments of as high as 80% if they wanted to purchase a second property.

Local governments can now decide if those people can be classified as first-time buyers, who are subject to downpayments as low as 30%. Chinese equities continued to sell off, which suggests that markets view these measures as insufficient.

Indeed, the downturn in the Chinese property sector is a structural phenomenon. This is an inevitable outcome given the structural rebalancing goal from debt-fuelled growth to sustainable consumption, against the backdrop of oversupply, slower urbanisation and demographic headwinds.

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