By Jan Faure
The extreme volatility that has been a hallmark of global markets this year continued throughout June. The heightened volatility demonstrates how uncertain investors are that central bankers will be able to contain inflation without triggering a recession. Inflation is a global challenge caused by Covid-19 supply-chain disruptions and surging food and energy prices as the Russia-Ukraine conflict continues.
Global markets declined in June with listed equities, bonds and real estate all suffering losses. In the US, the S&P 500 index closed out its worst first half performance since 1970. The index declined 8.4% in June and was down 20.6% year-to-date (end-June). The tech-focused Nasdaq Composite index declined 29.5% over the six months, marking its largest ever percentage drop for the first half of a year. MSCI World, which captures companies across 23 developed market countries, declined 8.8% in June and was down 21.2% for the first half of the year.
There were very few places to hide in the first half of 2022. Global bond markets, traditionally a safe-haven for asset allocation, have not been spared. The Bloomberg Global Aggregate index, the flagship measure for global investment grade debt that includes government and corporate debt, was down 13.9% for the first half of the year.
US – Fed raised rates to temper inflation
In the US, the Federal Reserve raised interest rates by 75 basis points at its June meeting, its largest rate hike since 1994. This came as CPI inflation data unexpectedly climbed in May, defying consensus views that inflation had peaked in April. The Fed has raised rates a cumulative 175 basis points this year. Projections are for another 125-175 basis points in policy tightening this year and next.
Fed chair Jerome Powell has come to the realisation that something has to give, saying, “frankly, the events of the last few months around the world have made it more difficult for us to achieve what we want, which is two percent inflation and still a strong labour market.” He still however believes it is possible to achieve a soft-landing – i.e., slowing down growth to get inflation under control but not so much as to cause a recession.
Europe – recession fears grow in anticipation of higher rates
The European Central Bank is set to end asset purchases on July 1 and hike interest rates by 25 basis points at its July meeting. That would be the ECB’s first interest rate hike since 2011. There are growing fears that raising interest rates while the Eurozone recovery is still fragile will push the region into recession later this year.
UK – BoE raised rates in response to inflation
In the UK, The Bank of England raised its key interest rate to the highest level in 13 years, from 1% to 1.25%. Inflation for May was 9.1%, a 40-year high, driven by higher food, fuel and energy prices. The BOE has warned that it expects inflation to climb past 11% by the end of the year.
Source: Trading Economics
With the S&P 500 index having entered a bear market in June, the obvious interpretation is that market participants are pricing in an impending recession in the US. The bulls had much of their hopes resting on inflation having peaked in April and the US consumer remaining resilient. The importance of the US citizen’s financial wellbeing cannot be understated as 70% of US GDP is driven by consumer spending.
US Consumer showing signs of pressure
Notwithstanding the pick-up in inflation in May, cracks have started to appear with the US consumer. The Conference Board’s Consumer Confidence number for June declined to a 12-month low. That dented the belief that the Fed can engineer a soft economic landing, as it is premised on the American consumer holding up through the policy tightening cycle.
The drop in consumer confidence followed a weaker reading for US retail sales in May (-0.3% m-o-m), indicating that Americans are reducing spending in the face of higher prices. May’s drop in retail sales is the first so far this year and sets the scene for the second half of the year when Americans will be tested on their willingness to dip into savings in order to continue spending. It highlights the delicate balancing act the Fed faces when raising rates to combat inflation without starving out too much growth (spending).
US Personal Savings Rate drops
The personal savings rate (ratio of personal savings to disposable income) in the US dropped to 5.4% in May. This ratio was between 7% and 8% pre-Covid and at 34% at the height of Covid stimulus measures in 2020. The drop in the personal savings rate indicates that consumers are feeling the pinch from higher prices. It seems inevitable that US economic growth will reflect the tightness in consumer pockets to some extent in the second half of the year. The real challenge may only appear in 2023 when the buffers that families built in 2020 have diminished more significantly.
If consumer prices remain elevated into the second half of the year, it is very hard to believe that people will continue consuming at the same pace they have been and be comfortable depleting savings. This brings into focus the importance of US Fed, and other central banks, in taming inflation. If consumer prices remain elevated for an extended period of time a recession is inevitable, so they need to act.
It is also important to note that people in developed countries are not used to inflation. It is a foreign concept for many so may take time to adjust spending habits. With food prices at all-time highs, energy prices supported by geopolitical risks and poor inventory levels, the pressure on family finances can quickly lead to higher levels of indebtedness for middle-income families.
Higher interest rates, and the resultant higher debt servicing costs, have begun to flow through into the real economy. Over the last 6 months, the US 30-year fixed mortgage rate has increased from 3% to 5.7%, severely undermining housing affordability. This will have direct knock-on effects on housing activity and the homebuilding industry, with expected second-round effects on consumer spending.
US Corporate Earnings Have Held Up Well
Tied to the US consumer is the US corporate which has for the most part been able to pass on higher prices to customers. As a result, US corporate earnings have held up well despite inflationary pressures. Consensus revenue and earnings growth is expected to come in at around 5% and 10% respectively for Q2 (Factset). That is hardly a sign of a looming recession, but investors will be looking for clues into the state of global supply-chains, input cost pressures and customer durability going forward. As in the past, there will be many eyes on the big-name multinationals with both disappointments and positive surprises capable of having a meaningful impact on market sentiment. At the same time, investors will assess forward earnings revisions against expectations.
There are three elements to the inflation problem, each with their own nuances:
Fiscal support drove savings – and consumer demand
The demand side of the US economy has held up well (so far) thanks to the US government response to the Covid pandemic. The fiscal response to Covid was so strong that US savings are $4.5 trillion above pre-pandemic levels. These extra savings have helped hold up consumer demand despite higher prices.
Demand driven inflation is far easier to target with monetary policy than the supply side inflation. The Core PCE Price index (personal consumption expenditures excluding food and fuel) has declined over the last 3 months from a peak in February (5.4%) to 4.7% in May, indicating waning consumer demand in the face of higher prices. The YTD decline in financial markets also negatively impacts household wealth and has the ability to curtail consumer’s willingness to spend, especially on discretionary items.
Supply driven inflation takes time to reverse
Supply driven inflation, especially in commodity markets, has a large structural element caused by years of underinvestment in new supply sources and can only take time to reverse. Added to this, the disruption to manufacturing and logistics caused by Covid-19 created shortages in raw materials and processed goods, while Russia’s invasion of Ukraine disrupted a key region for food and energy commodities.
Super-efficient supply chains, fine-tuned over the last 30 years, have had a profound effect on lowering prices of goods around the world. One of the longer lasting consequences of the pandemic, something only time will tell, is the shift to less efficient global manufacturing and trade due to risk mitigation efforts following the pandemic. The biggest loser seems to be China, which is still grappling with Covid lock-downs due to its tough zero-Covid policy.
As recession fears gained momentum in June, commodity prices across the spectrum cooled. Copper prices, considered a bellwether for the global economy and a recession indicator, dropped to an 18-month low towards the end of June. Oil prices also felt the heat from recessionary fears, with Brent crude declining by 5.7%.
Second half ahead
Looking ahead, volatility will likely continue to be elevated in the second half of the year. We expect acute attention being paid to key economic data points for clues as to the health of major economies. For global markets to stabilise and change trajectory in an upward direction, a few key dynamics need to improve or stabilise:
Sentiment is overwhelmingly negative, with market participants seemingly obsessed with the idea that a recession is coming. We believe there is a greater recession risk to Europe than the US due to the serious energy crisis on their doorstep. At the mid-point of 2022, the US yield curve is not flagging a recession, US employment is strong, American’s finances are intact, and the US dollar is holding its ground. There are however factors out of policy makers’ control that need to play out favourably in order to avoid a recession.
GLOBALINDICATORS: Local reporting currencies