Financial Update from Brewin Dolphin - 28 July 2023

July 2023

The Weekly Round-up

Friday 28 July 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, gives his take on second quarter earnings season and analyses policy announcements by three major central banks.

As we have discussed over the last fortnight, this is an interesting time for markets. Investors are digesting second quarter earnings from the US (and, as importantly, the guidance companies are offering for the rest of the year), together with three major central bank policy announcements, at a time when liquidity is draining out of the market due to the summer holiday season.

Earnings season

We are essentially halfway through earnings season but that means most of the major sectors and industries have had their tone set and we can start drawing conclusions. The easy bit is to look at some key metrics such as the fabled ‘beats to misses’ ratio (how many companies issued above consensus results and how many were below). This ran at an impressive sounding 80% rate but, in reality, it is a normal result. Equally common is the 50% of companies who have theoretically surprised the market with the strength of their sales. Perhaps more importantly, eight out of the 11 sectors of the US market experienced outright sales growth, with seven of them converting those gains into higher profits. Overall earnings seem to be rising by 3-4% and analysts have been sufficiently pleased with the messages from companies to edge their 12-month earnings forecasts higher.

In Europe, the picture has seemed a bit less positive. The eurozone flirted with a recession and that is perhaps partially reflected in a weaker earnings season (although most European and US companies are global in their activities). Only around 50% of companies have issued positive earnings surprises, and sales and profits have, on average, declined. The composition of those celebrations and disappointments is similar in both the US and Europe, with commodity-based companies suffering the most severe declines in sales and profits due to lower commodity prices. Telecoms have been weak in both regions too.

Unlike the US, analysts have been paring back their forecasts for Europe, although that reflects the weakness of the dollar which will inflate the translated overseas profits of US companies (and vice versa for their European peers). Broadly, both earnings seasons seem to have been taken reasonably well by analysts so far.

The ECB’s conflicting priorities

The fact that Europe only narrowly avoided a recession might seem incongruous with the European Central Bank (ECB) raising interest rates to a (joint) all-time high on Thursday. Guidance, though, seems to have switched from implying that further interest rates lie ahead to a stance of data dependency, which few would argue with under the current circumstances. Inflation expectations and wages still seem to be rising despite the easing in some cost pressures such as gas prices.

This reflects the tightness of the European labour market with unemployment at an all-time low and firms’ desperation for staff being enough to tempt more people into the workforce. These conditions might seem to argue that further interest rate increases are warranted, especially as provisional estimates of inflation for July initially look to be on the high side for a few European countries. There remains, though, a decent body of evidence that the economy is slowing – from the purchasing managers’ indices (PMIs) to money supply contraction.

The US economy continues to show evidence of achieving a fabled soft landing. Jobless claims remain low, but should pick up in a few weeks’ time based upon the WARN (Worker Adjustment and Retraining Notification) notices issued to employees facing potential layoffs. Durable goods orders picked up by their most in nearly three years, but we should be a little wary of these data as they are skewed by the remarkable recovery in civil aircraft demand, where supply issues are taking longer to dissipate than the rest of the economy. So called ‘core’ capital goods were little changed over the month.

Inflation eases the Fed’s dilemma

The Federal Reserve raised interest rates by a quarter of a percentage point. The Fed’s summary of economic projections suggests that there will be a further hike as well this year, something which Fed chair Jerome Powell has consistently presented as the expectation of the majority on the committee. Investors though are doubtful – preferring to believe that rates are at their peak for the current cycle.

So like other central banks, the Fed is in data-dependent mode, and king among all data in that context is inflation data. While inflation continues to slow, and acknowledging that interest rates are probably at a restrictive level now, it gives the Fed licence to sit on its hands. Any wavering of that downward trend would complicate matters significantly with unemployment still low and the economy estimated to be operating around full capacity. We have discussed the various indicators that home construction and sales may have weathered the storm of higher interest rates already, and this week saw the US house price index pick up to emphasise this point. This raises some debate about the transmission mechanism of monetary policy, because as interest rates begin to affect the corporate sector more than the consumer sector it is worth considering whether they might actually raisethe cost of supply unhelpfully, rather than diminishing demand as desired.

For the time being, though, interest rates and bond yields stand above market-based expectations of future price increases, which suggests that policy is restrictive and set appropriately.

But herein lies a discussion about the effectiveness of central banks in controlling inflation. Is inflation moderating because of monetary policy, or would the unlocking of supply chains and the easing of energy markets have achieved most of the moderation of prices regardless of interest rates? Most likely it was a combination of factors.

BoJ steps towards the exit

In Japan, we have speculated about the need for the Bank of Japan (BoJ) to change its own ineffective inflation-targeting policy for several months. The policy of yield curve control was embarked upon in 2016 when conventional quantitative easing risked causing the central bank to acquire too much of the Japanese government bond (JGB) market. It has been successful in slowing the pace at which bonds were acquired but was unsuccessful in generating inflation. Now, despite the policy, the Bank of Japan’s ownership of the JGB market exceeds 50% and inflation has at last returned (although few would ascribe the inflation increase to the yield curve control policy). It seemed inevitable that the policy would need to be loosened once more or disbanded entirely, but the central bank would want to do so without seeing bond yields jump too sharply.

Today’s announcement achieves that through a little strategic ambiguity. Rather than explicitly loosening policy, the Bank of Japan has said it would only rigidly enforce yield curve control if yields were to reach 1%. The current band of -0.5% to +0.5% would remain the reference range of ten-year yield fluctuations. It is not entirely clear what this means except that the central bank will nimbly conduct market operations between 0.5% and 1%. The message therefore is that the BoJ accepts that yields may need to be higher than 0.5% but they won’t be allowed to go higher than 1%. If speculators try to get them there, they are exposing themselves to losses driven by these nimble bond purchases which could occur at unknown yield levels in between.

While frustrating to investors it seems a neat solution to the ‘exit strategy’ problem that has been evident since the policy was introduced. The market’s reaction was volatile as investors digested this change which was presented as not being a change. Yields, however, rose by a significant but untroubling 0.1% and the yen rallied. The net result of this was modest losses across the Japanese market with the exception of the banking sector, which posted decent gains in anticipation of higher interest rate margins.