Financial Update from Brewin Dolphin - 26 May 2023

May 2023

The Weekly Round-up

Friday 26 May 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the latest haggling around the US federal debt ceiling and potential further interest rate hikes in the UK.

In mid-April, the MSCI World stood an impressive 20% above its October low, reaching a level it had failed to surpass in August 2022 and February 2023. Since then, it has traded in a range. This week, it edged towards the bottom of that range, whilst coming to terms with uncertainty about the monetary outlook, the fiscal outlook and the growth outlook.

The US debt ceiling

The main news was the back-and-forth discussion on raising the US Federal debt ceiling. The core of the challenge here remains the same: Democrats control the White House and Senate whereas Republicans control the House of Representatives. These groups need to agree to raise the amount the government is allowed to borrow; otherwise, eventually, the government may default. Default could arguably be avoided through some unorthodox interpretations of the constitution, but the legality and political ramifications of doing so are debateable.

Default on US debt remains a possibility and in recognition of this, Fitch announced that it will place the US on credit watch, indicating that a downgrade is becoming increasingly likely. Investors were fearful about the implications of the US losing its AAA rating (as the UK has) because US treasuries are considered the safest financial instruments in the world. In 2011, S&P took the unprecedented step of downgrading the US without causing a financial apocalypse. However, we wouldn’t want to be too complacent about further downgrades, as some investment policy statements specify the highest quality investments as those that have the highest rating from one, rather than all, of the major credit rating agencies. The implications of more downgrades could result in substantial selling of treasury bills.

That could happen without default if agencies were to belatedly follow S&P’s example. There is, after all, clearly a tangible risk of default. If that default came, what would the implications of that be?

According to analysis by the White House Council of Economic Advisers, a brief default could cost the US half a million jobs and 0.6% of GDP. A more worrying scenario would be a protracted default, which might lead to eight million job losses and a 6% contraction in GDP. The reality is that nobody knows what the implications would be, but certainly it seems reasonable to expect the prospect of a protracted default on US debt to have very serious implications.

Thankfully, talks have been surprisingly constructive. Perhaps not quite as buoyant as last week when the market rallied on positive noises coming out of the discussions, but we are beginning to hear details of what a deal could look like.

Rumours suggest that Republicans have been able to protect defence spending (which Democrats felt should be cut in line with other programmes) and secured some concessions on permitting fossil fuel projects. Democrats on the other hand may win support for upgrading the country’s electric grid to support greater use of renewable energy and have so far remained unwilling to place additional work requirements on the recipients of welfare.

Whilst the details of any prospective deal remain mired in secrecy, for the time being, conservatives are concerned that the result might not meet their expectations and have made that point to the speaker. If they are not placated, the speaker’s position could be challenged in a move which would take precedence over other business and form a procedural roadblock to passing further legislation. The threat remains, but it is much less clear what could be gained from it over the long term. Whilst Freedom Caucus members made a nuisance of themselves during Kevin McCarthy’s election to the role of speaker, they were clearly unable to promote any alternative candidate.

Alongside this fiscal uncertainty, the outlook for monetary policy is mixed. The market continued to anticipate interest rate cuts by the end of 2023, but much less significant ones than had been expected a few weeks ago. Tentatively, it seems as if the turmoil in US regional banks is not having too much effect on credit supply to the economy (so far at least).

Interest rates in the UK

The interest rate outlook in the UK tightened further, though, as inflation is proving disappointingly persistent. Whilst the overall inflation rate fell below 10%, it did not decline as much as had been expected given that the astronomical increases in utility bills from April 2022 dropped out of the annual calculation. Underlying inflation continues to gain ground with core inflation reaching its highest level, on a seasonally adjusted basis, in over thirty years. Core inflation (excluding volatile prices of food and energy) gaining speed will be alarming to the Bank of England (BoE). The BoE observed some moderation in input prices, which should translate into lower inflation for consumers, but relatively high wage inflation and a lack of capacity in the UK economy continues to drive prices higher.

Many forecasters believed the Bank’s Monetary Policy Committee (MPC) might refrain from raising rates to reflect the work it has done so far to suppress inflation. Now it seems certain it will need to hike rates again in June. The market is currently anticipating that interest rates will rise a full percentage point, peaking at 5.5% at the end of 2023. The dilemma for the BoE is whether it has tightened enough, and now has wait for that tightening to take effect (as mortgage holders refinance). Or, alternatively, whether it needs to tighten more in recognition of the lag before its actions are reflected in price moves.

Whilst central bankers always aim to control inflation without triggering recessions, it is very unusual for them to be successful. For the BoE, protecting growth is a luxury it will find it hard to afford. Retail sales numbers for April, released this morning, showed that while consumers are hardly splurging, they are certainly showing remarkable resilience in the face of sharp price increases. Under current circumstances, policymakers would like to see them showing a little more discernment.

Politically, the persistence of inflation forms a particular challenge. The prime minister announced the halving of inflation to be one of his key objectives for the year. At the time, it seemed a cynical attempt to take credit for something that would happen regardless, but there is a small but growing chance that the target could be missed. In addition, the government presumably hoped to spend this year taming the budget deficit and inflation in order to be able to embark on some pre-election giveaways next year. In data released this week, we saw that borrowing for the last fiscal year was lower than expected, but borrowing at the start of this year has been higher, with surprisingly low tax receipts, despite the relative strength of the economy and expensive inflation-linked bonds to service.

AI stock boosts

Whilst worrying about inflation and growth, the one topic the market has become extremely positive on is artificial intelligence (AI). This has seen stocks associated with the theme getting a strong boost, but atop them all stands the chipmaker, Nvidia. Investors see tremendous potential in AI, which is reflected in applications like ChatGPT and Google’s Bard. They see Nvidia as providing the tools companies will use to exploit those opportunities.

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.