Financial Update from Brewin Dolphin - 25 November 2022

November 2022

The Weekly Round-up

Friday 25 November 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the outlook for the US economy, recent Covid-related deaths in China and a retreat in the oil price.

Next year could see history’s most anticipated recession. At the tail end of this year, we are starting to see the evidence of declining economic momentum in the US. However, a recession is far from certain and, indeed, credible forecasters are upgrading the chances of a ‘soft landing’, in which the inflationary pressure eases after a period of interest rate increases, without the economy sliding into a recession.

The slightly increased chance of a soft landing is reflected in the better performance of stock and bond markets, although a recession next year remains our base case. We can also see it in the current strength of the Atlanta Federal Reserve’s GDPNow estimate of how strong the economy is growing in the current quarter. With the labour market remaining resilient, and this week’s better news on the investment front (orders for capital goods and machinery were reasonably strong), the US economy is expected to expand quite briskly – for now at least.

Clouds loom over Wall Street

Nevertheless, clouds are looming over Wall Street, as evidenced by the recovery in bonds and on Constitution Avenue where members of the Federal Reserve ponder the appropriate stance of monetary policy. In the Fed’s last meeting, interest rates were increased by an eye watering 0.75%. This week saw the release of the minutes of that meeting. These can be very insightful, even though they are weeks old and the committee’s thinking may have evolved since they were written.

The key takeaways were that members of the Federal Open Market Committee (FOMC) are becoming more concerned about the economy. For example, they view the risks to growth as being skewed to the downside, they observed that the impact of higher interest rates takes time to affect the economy and, perhaps most crucially, they see the probability of a recession as being around 50%. What are the implications for monetary policy? It is assumed that interest rates will be increased by 0.5% on 14 December. Thereafter, rates are likely to rise until around May.

A recession has been feared for months, but whywhen the economy seems robust? The challenges of adjusting policy so fast, and loosening a labour market which is so tight, seem insurmountable for policymakers who have historically found it very difficult to tighten without tipping the economy into contraction.

Is there any evidence that this is happening? This week saw the release of the purchasing managers’ indices (PMIs), gauges of business activity which fall somewhere between sentiment and hard data. Companies are asked whether certain aspects of their business are currently expanding or contracting; the balance between respondents in either camp is assumed to be a proxy for the aggregate strength of the economy.

The cleanest measure of demand in the economy would seem to be the gauge of how many companies are seeing their new orders increase, relative to those who are seeing their new orders fall. What the PMIs showed is that around the world the balance has shifted in favour of the latter. The rationale for these declines (as reported via the surveys) is that in Europe inflationary pressures are harming demand, whereas in Asia and the US greater emphasis is placed on the restrictive monetary policy.

Monetary policy in Japan

One region in which monetary policy is not particularly restrictive is Japan. Japan does not have such a severe inflation problem as other regions, with prices rising at just under 4% per annum. While that is a far cry from the double-digit rates seen in the UK, it is also the highest inflation Japan has experienced in four decades.

The Bank of Japan (BoJ) has left monetary policy unchanged, but that belies the nuances that exist in the current stance of policy. Japan has committed to keep ten-year bond yields within a range from as high as 0.25% to as low as -0.25%. For the last year or so, the BoJ has been persistently pushing against that upper boundary. The BoJ maintains the boundaries by buying bonds above the upper threshold, which is broadly a policy of quantitative easing. This effectively means policy loosens even as investors speculate that it will need to tighten. At some stage, particularly if the policy is successful, the BoJ will need to allow yields to rise further, laying the ground for a potentially very abrupt change in monetary policy.

China’s Covid challenge

Chinese markets have had a tumultuous time since the National Congress of the Chinese Communist Party last month. Markets plunged on the appointment of a largely hard-line nationalist politburo membership, devoid of the liberalising and reforming influence that had supported China through two decades of economic outperformance. Since then, markets have rallied sharply, which has been attributed to efforts by the refreshed leadership to ease Covid restrictions and stabilise the ailing property market. While concerns remain about the ideological vision of the leadership, and particularly what role profit motive would play in China, this week further challenges have emerged to the Covid-easing hypothesis.

The week began with news of the first official Covid- related deaths for six months. Hong Kong’s chief executive John Lee tested positive for Covid mere days after meeting Chinese president Xi Jinping at the ASEAN summit. Since then, case numbers have continued to rise, surpassing the peak seen during this year’s previous spike. Measures to prevent the spread have been coming thick and fast and in many forms. Schools have moved online, those travelling between some cities are required to quarantine, and visitors to Beijing are required to post a negative PCR test before using buses or entering public buildings. In a sense, this is an early test of theXi authoritarian approach. A policy of Covid mitigation has been imposed from above, and it has subsequently come with a 20-point plan on how to ease lockdown rules. Now, regions are struggling to find ways to meet objectives and abide by the rules.

With liberty being constrained and the virus still circulating, frustration is growing. The critical measure which might facilitate a more rapid easing of measures is the vaccination rate, but that remains stubbornly underwhelming. It is understood that 60% of those aged 80 and above have been double vaccinated, whilst 40% have been boosted. Authoritarianism can maintainseemingly intolerable lockdowns whilst being unable to compel people keep up their vaccinations. Workers at Apple’s Foxconn factory were moved to violence after being subjected to lockdowns whilst also exposed to the spreading infection. Supermarket shopping apps have been overwhelmed by demand in response to and anticipation of restrictions on movement. High frequency data is enough to confirm that economic activity is grinding to a halt.

Oil price in retreat

The economic slowdown in China, and the impending slowdown elsewhere, has been enough to force the oil price into retreat. The price has flirted with its lows for the year. Weaker Chinese demand for energy reduces gas needs too, reducing the price of transported liquified natural gas. This is particularly helpful to Europeans and frustrating to Vladimir Putin’s plans to exert pressure on the West by restricting gas supplies.

Europe is also seeking to intensify pressure on Putin by restricting the price of Russian gas such that oil profits will play less of a role in funding the Russian war machine than they had done previously. The mechanism for doing so is a cap on the price of oil to be observed by those facilitating (shipping and insuring) the transport of that oil. Agreement, however, has been elusive among member countries, with Poland and the Baltic states seeking a low cap with the obvious objective of inflicting as much pain on Russia as possible, while Greece with its shipping interests would like a less restrictive cap. Russia, for what it’s worth, initially promised not to export oil to countries observing the cap, but has since softened its position, saying it will respond once the level of the cap is known. Most EU members would like to see Russia sufficiently incentivised to sell them the oil they need, but earning less from those sales with which to fund the war in Ukraine. After failing to reach a resolution on Thursday, talks continue.

Economic gloom also continues, but the potential pivot in monetary policy has provided a real boost to financial markets. This weekend also offers opportunities for bargain hunting, with retailers expected to be generous in their attempts to clear inventory. And the World Cup, which has provided more than its fair share of disappointment off the field, is shaping up to be a fascinating contest

The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.