Not Much Has Changed

Week Ending 16 June, 2023

Following a two-week absence, it’s interesting to see if anything has materially changed on the big picture front. The short answer is not much:

It was predicted the Fed would pause rates at its next meeting on 14th June – and they did. Of much more interest was what the 18 policymakers had to say about the outlook. 12 “pencilled” in rates above or equal to the median range of 5.5% to 5.75% - as demonstrated in the dot plot below for 2023. This means two more rate hikes are anticipated in July and September. The Hawks still prevail – this pause is just a precautionary step to “assess additional information and its implications on monetary policy” given that the full impact of these many rate hikes is yet to flow through. For the Hawks, inflation pressure is still running high and now, more than ever, the Hawkish members are very mindful the task of bringing inflation down is proving harder and longer than originally envisaged. Powell was quick to dismiss the idea of rate cuts this year as he and the other members still see risk to the upside. In his statement he said (of rate cuts) being probably “a couple of years out….when inflation comes down significantly”. This is quite a telling statement which I believe is somewhat at odds with the dot plot picture below. The latter shows the 18 members’ expectations of rates further out. For 2024, 13 are now forecasting varying degrees of rate cuts (mostly -0.5% to -0.75%). However, 2025 is when they really expect the boot to drop with most anticipating steeper cuts. In the longer-term (2025+), most fall in line with the 2025 view. Meanwhile, the Fed continues to reduce its security holdings at a quick pace keeping financial conditions tight. Powell admitted “we’ve covered a lot of ground and the full effects of our tightening have yet to be felt”. The latter will impact debt rollovers when they become due. It’s not such an issue this year.

‍

Speaking of inflation, the continuing decline in energy inflation sent the headline (= nominal) rate down to 4.0% y/y but core inflation (headline minus energy and food) ticked up 0.44% in May to 5.35% y/y. Shelter inflation is now the main driver of the headline rate rising at roughly 0.5% pm – but is showing glimmers of slowing down. Owners’ Equivalent Rent is plateauing while Rental Inflation is dropping fast (from well over 15% y/y to about 5% y/y now). It’s one reason why the Fed’s most preferred inflation measure is the PCE index (Personal Consumption Expenditures Index) – it comes closest to measuring services inflation, the very same inflation that consumers feel the most. If this trend continues, this could be the last, big core inflation print this year falling to 4.2% by year end (Goldman Sachs (GS)).

In the UK, regular wage inflation (excluding bonuses) surprised to the upside and is growing at 7.2% y/y for the quarter to April (vs 6.7% y/y previously). Contrast this with UK CPI Inflation which has slowed to 8.7%. At this rate, it will not be long (see the lines on the chart below) before they meet – at which point we move out of negative real wage growth territory. Meanwhile, as demonstrated by recent employment data showing unemployment dropping to 3.8%, we continue to operate in a very tight labour market and this raises the spectre of further rate hikes to come. Based on recent Bloomberg World Interest rate Probabilities, markets are bracing for five more rate hikes this year taking it to around 5.8%. Currently, it stands at 4.50%.

If this plays out, surely the consumer will sink on the home mortgage front? Well, the picture has changed somewhat. A DB study shows outright UK home ownership stands at 55%. This is the highest since 1981. Put another way, 45% of homes are under mortgages. Of the latter, the share of mortgages on variable rates has declined dramatically to 15% (from a peak of 72%). Now, only 13% of mortgages refinance this year. In the past two years, 5y fixed-rate mortgages have risen 40% to being 50% of new mortgage products. This is a fast turnaround – it’s almost as if the BoE could afford to hike rates further as its weighted average R* equilibrium rate has moved up! It does not mean clear skies though. Back in March, the effective (weighted average of all mortgages) mortgage rate was about 2.75% while, the new mortgage rate being set at the same time was 4.41%. This gap has widened further with the average 2y and 5y fixed rate mortgage starting with a “5” in front of it. The question is simply whether this is delaying the agony or helping to buy the consumer time to avert a crisis? Worryingly, the same DB analysis estimates only a quarter of all the rate hikes thus far have actually come through to the housing market. For corporates, that comparable figure is 80%. If rates don’t fall in time, then it’s down to growth…..

….and Growth rebounded 0.2% m/m in April (vs March: -0.3% m/m) driven by services. It’s worth noting March was characterised by plenty of industrial action which ate into output issues. Industrial action hasn’t gone away so actually if we bounce around the +0.1% / +0.2% pm mark, it keeps things ticking over and almost demonstrates a base performance level for the UK economy – notwithstanding exogenous shocks!

Elsewhere, the ECB hiked rates +0.25% (expected) with their projections showing higher expected inflation while still positive on growth; China’s monetary conditions came in softer than expected as was its activity data. Growth momentum weakened dragged down by slower industrial production & fixed asset investment growth; China’s inflation rates remain very low (headline rate notched up to +0.2% y/y while the core rate edged down to +0.6% y/y). Not surprisingly, the Central Bank eased rates -0.10% to 2.0% - surprising markets and perhaps sets the scene for more cuts to come in its other rate mechanisms. India’s industrial production growth maintained its momentum helped by manufacturing. Inflation fell to a 2y-low of 4.3% y/y.

What does it mean and how are investors positioned?

A pause is a pause! Pauses and restarts will very likely be the way forward from here. What Central Bankers are saying is the full effects of recent rate hikes have yet to fully work their way through into the system and they want to see what impact this has. The DB analysis above demonstrates how only about 25% of rate hikes so far have manifested their way into the UK mortgage markets. The inflation battle is far from over but is headed in the right direction. Retail sales (as evidenced by US data this week) remains in positive territory.

What it comes down to is when (if at all) does the debt mountain crack in an environment of higher rates? I came across this chart showing maturities in the speculative debt space for US and European leveraged speculative grade maturities:

It shows how debt maturity walls have been narrowing over time. For example, in the US (left chart), debt maturing within 2 years end of (EO) April 2023 has risen to 9%. Prior to this, it was between 3% to 5% (2015 to 2021). For Europe (right side) the figure is 12 (vs 3% to 6% in prior years). At a consumer level, many home-owners are still in fixed-rate mortgages, some with very low rates locked in for many years (e.g. US, much of Europe). So from a cash flow perspective, the “pain” is not being felt. Investment Grade companies have the cash and generally obtain better financing terms. What happens next all comes down to debt rollovers – both corporate and consumer!

Investors often confuse the disparity (almost 6%) between Manufacturing and Services activity and therefore conclude a recession is inevitable. A word of caution here as evidenced by GS research: (1) cyclicality plays its part – during tighter financial conditions, this gap tends to increase during positive but below-potential growth (which is what we have today); (2) Pandemic factors are still normalising – we have gone from high goods demand to high services demand. High stock levels during the pandemic are still washing their way through the system and (3) import demand is soft with China being a key factor. This is impacting manufacturing in high-base manufacturing countries. It’s a chain – we need Chinese services to pick up which, in turn, drives up manufacturing which then boosts import demand from surrounding nations.

Take a look at the BoA Global Fund Manager Survey chart below. It’s quite stark in terms of positioning sentiment.

In terms of June rotation, the US/Japan has outperformed the EU/EM; by sector, Healthcare/Telcos has outperformed Banks/Energy. Should we be worried about the big rally we have witnessed in tech-related names? The NASDAQ Composite is +31% YTD vs the S&P500 +15% YTD. The NASDAQ Composite comprises 3,000 names with almost 50% to technology, 20% to consumer services and 10% to healthcare. The S&P500’s allocations to these same sectors are 29%, 18% and 13% respectively……and is spread out across other sectors too (Financials 12%, Communication Services 10%, Industrials 8% amongst the main ones). So you can see the impact technology has had this year! Question is, is it sustainable? A large driver of the frenzy in tech is AI (Artificial Intelligence) and especially the advent of ChatGPT. There’s no denying it, this is a game-changer in terms of elimination layers of lower-level manual type white collar jobs. It’s here – it is being deployed. Is it perfect? No! But if you’re an employer who has been struggling for over a year to find someone to fill a job post, it’s worth trying AI. Some productivity is better than none at all and the cost is a fraction of hiring and maintaining. Besides, given the generally poor quality of worker skills out there, it’s not like the bar is that high to begin with!

There are all sorts of forecasts of how much AI will boost GDP and Earnings Per Share (EPS). No one really knows – there are similarities to the start of the dot.com era – which ended up in a bubble, followed by a consolidation of companies and a massive correction in pricing. This time round, we are dealing with established companies and it’s almost impossible to say how profits will be generated and therefore priced in. I think the first task is for AI to soak up the gap between jobs for hire and job applications. That alone is massive. In the US, there are some 10mn wanted ads. They are not all going to be desk-based (these being the ones more prone to AI substitution). As for physical roles, they will take much more time – the latter require investment in design & concept, trials & testing, plant & equipment. You don’t do this overnight! It’s scary when you look at how high Netflix stock has risen – but then just try and fathom how big their immediate and potential latent market size is and it’s mind boggling.

MARKET SUMMARY