Where Are We Headed?

Week Ending 26 May, 2023

This weekly is on the early side and I am wary of what Friday brings, especially as the debt ceiling saga gives rise to further bond market volatility. The table below is yesterday’s COB snapshot but the 1m US Treasury is now yielding 6.046% (+0.294% on yesterday!) while Gold trends lower (now $1,960.40). So far this week, we have had confirmation of the following:

Asia: The Asian recovery continues slowly & in spurts as it’s clearly intertwined with China’s progress. The Chinese Central Bank (PBoC) has once again kept its 1y (business) and 5y (mortgages) rates on hold at 3.65% and 4.60% respectively. Importantly, it has good scope to cut further if it feels the need to re-energise its economic recovery. Furthermore, it has other levers at its disposal (e.g. the RRR, Reserve Requirement Ratio). India saw a +13.1% y/y rise in exports while additionally its inflation fell to 4.7% y/y. In all likelihood, this will fall back further if one views its WPI (Wholesale Price Index) which also fell. The passthrough effect from the latter should bode well.

‍Activity: We had flash (estimated) activity data released on Wednesday and it was a similar story – services buoyant (i.e. comfortably expanding) while manufacturing is still sluggish/contracting. The latter is tied to the China factor e.g. Europe, especially Germany.

‍Investment: A GTAI survey revealed 2022 foreign investment was stable and attracted 1,783 new projects and expansions. This is just -23 down on 2021; it is +101 up on 2020 – that’s an impressive result and does not suggest in any way that Foreigners have lost faith in Europe’s biggest nation. The breakdown is interesting too: the US accounted for 279 projects in 2022 with Switzerland the second biggest (208) and UK third (170). China was fourth with 141 projects (lowest since 2014). So despite all the doom and gloom last year towards Europe given the Russia / Ukraine crisis, Germany at least remains a very preferred destination for investment capital.

‍Inflation: so far, all the relief in inflation has been at a headline level, specifically energy price declines. Today’s UK release was a good example - April headline inflation dropped to 8.7% y/y (March: 10.1% y/y). The sharp fall reflects a big drop in energy price inflation which contributed to a -1.8% fall. Furthermore, tomorrow, Ofgem (the energy regulator) is expected to announce a roughly -20% fall in energy prices for Q3 which will have a further downward energy price decline. Today’s fall was less than expected which, when adjusted for the drop in energy, means inflation has surprised to the upside for the third month in a row. Even more importantly, Core inflation accelerated to 6.8% y/y (March: 6.2% y/y). Service sector inflation has picked up to 6.9% y/y (March: 6.6%). All the latter will add to BoE worries. Some now expect rates to peak higher between 5.25% to 5.50%. In Singapore, April Headline inflation is rising 5.7% y/y while core inflation is rising 5% y/y. Travel-related services more than offset price declines in electricity, gas, food and retail. New Zealand raised rates +0.25% as expected – it cited stubborn inflation as the cause. At 6.7% y/y, it is more than double the top end of its inflation target. In South Africa, inflation rose again (to 6.8% y/y) driven by a weaker Rand (-10% YTD), power shortages and high food prices all of which are working their way across the economy. The Central Bank expects rolling blackouts (up to 10 hours per day) to add +0.5% to headline inflation.

‍So the key question: where are we headed? The resilience of consumers has been driven by low, fixed-rate debt and a stable, tight job market that is seeing wage growth close to inflation levels depending on where you live (e.g. negative real rates in Japan but the gap is closing and wages are likely to rise +4% in the coming year as part of the next pay rounds amongst large companies) to roughly neutral in say the US and parts of Europe. We are close to the R* rate, the equilibrium rate. Whether there are one or two hikes left is largely academic. In the absence of a big headline surge, the likelihood is that rate hikes are about to be paused. I doubt the BoE will focus too much on core inflation – it has a good excuse to focus on the headline rate. Same goes for the Q3. With that anticipated pause, we should get some sort of rebound in markets. Will it be a dead-cat bounce or the start of something fundamental? I suspect the former – because in 2H, towards Q4, China/India should be in full flow. That will drive a surge in hydrocarbon consumption sending oil prices higher. The latter will feed through into headline inflation. GS is forecasting oil at $95 per barrel by April 2024. The inflation uptick won’t be as severe as February 2022 went it went into triple digits per barrel – but still, it will reignite volatility in bond yields. The latter will affect the all the present value calculations!

Well before then, we have the debt ceiling negotiations. Yellen and co have been saying it’s all over by / during June. Leaving aside brinkmanship, they have July/August to come up with something before the next round of government expenses that need to be paid. There are mechanisms that can be deployed (e.g. the TGA, Treasury General Account which is the Treasury’s checking account). The latter has hit a very low level (less than a hundred billion) from its $1tn+ peak (2020). Expect the Treasury to turn on the QE press as it prints more bills driving up Bond yields at the shorter end of the Yield Curve.

‍MARKET SUMMARY