Financial Update from Brewin Dolphin - 28 October 2022

October 2022

The Weekly Round-up

Friday 28 October 2022

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses the market’s reaction to the new UK prime minister, disappointing results from US tech stocks, and a selloff in Chinese equities.

This has been another volatile week for financial markets, with key developments in UK politics, a global retreat in bond yields, and a selloff in US mega-cap tech stocks and Chinese shares.

UK politics

Rishi Sunak was named the new UK prime minister earlier this week. This has been well-received by financial markets as he is perceived to be a fiscally conservative and market-savvy heavyweight. UK government bond yields have fallen sharply across all maturities and are below where they were before the mini-budget. UK two-year gilt yields, which are more sensitive to policy rate changes, are down from over 4.5% to around 3%. Markets now expect UK interest rates to peak at below 5% in 2023, down from as high as 6.3% just after the mini-budget. Sterling has also staged a sharp rebound.

Although market stability is somewhat restored, there are still plenty of risks and the new government is treading on thin ice. In fact, Sunak has repeatedly warned about the economic crisis facing the UK and that tough decisions will have to be made. The latest purchasing managers’ business surveys suggest the UK is in contractionary territory. Inflation is at a 40-year high and the pound is still trading at near-historic low levels versus the US dollar. The UK is still suffering from a worsening budget and current account (twin) deficit. Markets are likely to continue pricing in a higher risk premium on UK assets.

The incoming prime minister is inheriting an economy in or heading into a recession, with little room for policy support. It is an extremely difficult balancing act. The next big focus will be on the medium-term fiscal plan, which is now delayed to 17 November. There could be potential spending cuts and tax rises (aka a return to austerity) as the prime minister and chancellor prioritise debt and fiscal sustainability. There is a massive fiscal hole to plug and there is no room for missteps; every figure will be subject to heavy scrutiny. The stars are aligning for the new PM though. The Treasury and the Office for Budget Responsibility (OBR) can now incorporate a more updated and, most importantly, improved set of market assumptions (lower gilt yields/interest rate expectations, stronger sterling, and a plunge in natural gas prices in recent weeks) into their macro projections that would allow room for less austerity than otherwise.

The outlook for the UK is no doubt challenging. The silver lining is that now fiscal and monetary policy are in-line to fight inflation. If inflation does moderate next year and UK credibility is regained, the worst of sterling and gilt volatility is past us. As UK short-term yields and swap rates retreat, mortgage rates will likely come back down as well which will provide some relief to homeowners. We continue to think the UK will experience a mild rather than deep recession.

US earnings season

The US earnings season is so far characterised by disappointing results from mega-cap technology companies and a free-fall in their share prices. Alphabet, Meta and Amazon raised concerns on a weakening advertising and consumer demand outlook, while inflation pushed up costs. A strong US dollar is also a headwind to overseas earnings. The fall in bond yields, which typically supports growth stocks, was unhelpful this time as investors focused on the earnings outlook.

As far as the US economy is concerned, there are more signs of weakening activity, particularly in the housing market. A measure of US home prices saw one of the sharpest monthly falls on record and annual growth has slowed sharply. New home sales were also trending down and pending home sales plunged over 10% in September. Third quarter GDP data showed US residential investments slumped 26% on a quarter-on-quarter annualised basis. These figures reflect the impact of higher interest rates, with US 30-year mortgage rates now above 7%, the highest since late 2000. Demand for mortgages has slumped as affordability has become increasingly tough. US third quarter GDP showed a decent quarterly (annualised) growth rate of 2.6%, which is better than expected, but the underlying figures suggest domestic consumer demand has slowed. Durable goods orders, a proxy for investment activity, contracted in September and the latest purchasing managers’ indices point to weak private sector demand.

These developments are likely to be read by the Federal Reserve as evidence that tighter financial conditions are making their way into the real economy and should dampen inflation with a lag. That said, the labour market remains very firm with little pickup in jobless claims. The employment cost index, which is a broad gauge of wages and benefits, rose by 5% year-on-year indicating resilient wage pressures. The Federal Reserve’s preferred inflation measure, the core personal consumption expenditures price index, continued to stay well above target.

So despite the signs of weakening data and slowing headline inflation, the Federal Reserve is on track to hike rates by another 75 basis points next week. The recent fall in US Treasury yields shows investors expect the FOMC to slow the pace of tightening after November’s meeting. Markets currently expect the Fed funds rate to peak at 4.8% in 2023, with around two 25 basis point rate cuts by the end of 2023. The risk is that this expectation proves to be premature if the Fed again decides to push back against this “pivot”.

A glimmer of hope for Europe

The European Central Bank has hiked its policy rates by 75 basis points. However, the meeting was considered dovish and eurozone bond yields fell across the board. While there is a wide acknowledgement that inflation is high and economic risk is skewed to the downside in the area, there is a glimmer of hope.

The biggest concern for Europe is arguably the gas supply crisis. The best news is that for the past two months, European natural gas prices have plunged. There have been two main drivers. First, over the summer European gas traders scrambled to offset the sharp decline in gas flows from Russia by boosting imports from other sources. Second, the weather has been warmer than expected. As a result, heating demand has been seasonally low. In a reversal from earlier this year, European natural gas storage levels are now a tad above the historical average. Since the surge in energy prices contributes to half of the eurozone’s headline inflation and is a key drag to households’ finances, the development is welcoming from both an inflation and growth perspective.

Carnage in the Chinese stock market

Chinese equities, in particular tech stocks in Hong Kong, suffered huge outflows and falls this week after the Communist Party Congress cemented president Xi’s unchallenged power. While it was widely expected that Xi would secure a third term, the announcements of who he selected and removed from key leadership positions spooked the markets.

Probably the biggest name that he removed from the Central Committee was his own premier Li Keqiang, who has historically been a big supporter of economic reforms. And while the next premier will not be announced until the National People’s Congress in March, it is expected that it will be Li Qiang, who is chief of the Chinese Communist Party (CCP) in Shanghai. This is because at the event on Sunday he walked out on stage immediately following Xi, and this individual typically goes on to become the premier. This appointment raised some eyebrows – while he has close personal ties with Xi, he doesn’t have any central government experience and he was criticised for his handling of the two-month lockdown in Shanghai earlier this year.

The fact that Xi stacked the Politburo with his loyalists and removed those from rival factions led to the turmoil in the Chinese markets. The concern is that Xi is now even more unconstrained to enact policies that may not be market friendly. Indeed, there is a disappointment that there is no indication of change to the Covid zero strategy and there is a lack of policy guidance or reform to support growth. The Chinese market is now very oversold. The silver lining is that the latest China GDP report showed the economy is picking up as the worst is probably behind us.