Financial Update from Brewin Dolphin - 8 July 2022

July 2022

Weekly Round-up

Friday 8 July 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist,discusses Boris Johnson’s resignation and evidence of a slowdown in the US economy.

Over the last week pundits became increasingly confident in stating that Boris Johnson’s premiership was inevitably going to end. The question was not if, but when that end would happen. Thursday’s announcement that he would resign paradoxically means he will likely stay in office longer (whilst waiting for a new leader to be selected) than he would have done had he been forcibly removed in a no-confidence vote by the parliamentary party.

The pound rose on the day but was likely being moved more by European gas prices than UK politics. The next UK prime minister will be determined by a Conservative leadership contest in which the party’s MPs slim down the field of contenders in successive rounds of voting until two are left. The winner is then chosen by a ballot of party members.

The process makes winners hard to predict, with relatively little known about many of the candidates and their potential visions for the country. All we can say with confidence is that almost any Conservative candidate is likely to be more fiscally conservative than the outgoing prime minister. No doubt all would dearly like to cut taxes, but the current state of the public finances and projected rise in inflation make that very difficult. That uncertainty reduces the market implications of this week’s political chaos such that any impact was barely discernible.

Japan is holding its upper house elections this weekend, which will now be in the aftermath of the tragic assassination of former prime minister Shinzo Abe. The ruling Liberal Democratic Party, which Abe once represented, was on track to make gains despite the cost-of-living crisis and plummeting yen. If there is any impact from this week’s grim events, it would seem most likely to engender sympathy for the party.

Not if, but when

Economies, as we have noted before, follow a cycle and inevitably that cycle ends in a recession. The question is when, not if the economy suffers a recession. Nevertheless, some have held out hope that we could see a soft landing (a slowdown in growth which does not end in a recession) when the post-pandemic boom ebbs – we’ve considered that to be unlikely.

Typically, a recession is considered to be two successive quarters of negative economic growth. By that criterion, the US may already be in a recession, but for it to officially be so the National Bureau of Economic Research (NEBR) would need to ordain it. The NEBR’s criteria are a bit more subjective, and we can’t be sure how it will balance the current slow rate of real growth and the contraction of real incomes against the incredibly strong labour demand.

More prescient than the nuances of what the economic intelligentsia consider a recession is the fact that there are signs of the momentum in demand just starting to ease a little. Weaker demand would be good news in terms of reducing inflationary pressures, but it brings challenges for businesses that are exposed to the business cycle. It was most evident in the housing market, from whence many slowdowns come. The abrupt increase in US interest rates has seen an equally abrupt decline in demand for US housing. It is not evident in house prices yet, which are supported by a shortage of available properties, but the inventory of newly built properties has begun to pick up.

Not now, at least

So much will depend upon the strength of the US labour market, which right now remains very tight indeed. Companies remain very concerned about their ability to retain talented staff during shortages even as the momentum seems to be shifting. The US job openings labour turnover study (JOLTS) reflected these trends with a very high level of job openings and a historically high number of employees voluntarily quitting their jobs. But both these measures are now declining, gradually but consistently, across the vast majority of sectors. The Challenger Job Cuts report observed that the first half of 2022 saw the lowest level of job cuts in an equivalent period for nearly 30 years, but also observed that, from that low base, job cuts rose by more than 50% from May to June.

No pausing, for now

As far as we can tell, there has been no wavering in the commitment of Federal Reserve members to continue raising interest rates. Federal Reserve governor Christopher Waller and St Louis Federal Reserve president James Bullard both reiterated their support for a rate hike of three quarters of a percent at the Fed’s next meeting on 27 July and another half a percent at the September meeting. Bullard and Waller are among the most hawkish members, but their words are in line with market expectations.

Investors are, however, beginning to take issue with the Fed’s longer-term projected path of interest rates. With evidence of economic momentum slowing, the market no longer expects rates to rise beyond February 2023 and rate cuts are expected in the following months.

So there is plenty of evidence that the labour market may be slowing but, for now, headline jobs growth remains strong. June’s payroll growth numbers, released this afternoon, didn’t slow as much as forecasters expected. According to the report, American firms employed another 372,000 people last month. The data is gathered by surveying companies, but an equivalent report measures employment by asking individuals whether they have jobs. For two out of the last three months, the household report has shown falling jobs in months when the nonfarm payroll report has shown really strong jobs growth. That means we have to be a little cautious about interpreting these data.

One measure investors and policymakers were looking for was a return to the labour force of people who left during the pandemic. However, the labour force participation rate felllast month. So overall, this report will be one that encourages the Federal Reserve to follow through with that three-quarter point rate increase later this month.

Danger remains

Valuations have improved and we are entering the second quarter earnings season, which should still show strong profit growth and could allow the mini rally to continue. However, there remain plenty of dangers. Europe is an area of particular anxiety due to the risks of a further interruption of gas supplies from Russia. Recession risks seem far more acute in Europe and this is reflected in an exchange

rate between the euro and dollar that is rapidly approaching parity.

Commodity prices have fallen sharply, a further indication that investors see recession risks ahead. Smaller falls for the oil price will be helpful in easing the cost-of-living crisis, but they have taken place at a time when energy supply remains inhibited

by disruption to Libyan supply and failure of negotiations to bring Iranian oil back to the market.

Prospective returns for investors in this market have improved markedly, but the immediate outlook is obscured by looming economic clouds and cautious positioning is warranted.