Market Perspectives September 2023
Read our latest round-up of the global themes, trends and events currently influencing investors.
Henk Potts, London UK, Market Strategist EMEA
Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.
Whether it is for the weather or the global economy, beware of making forecasts. That said, many economists might be forgiven for predicting that a recession would occur in 2023. At the start of the year, the apparently toxic combination of high inflation, the steepest rate-hiking cycle since the 1980s and stressed international relations, had all pointed to a contraction in economic activity.
However, consumers have been spending far better than expected this year, labour markets remain in relatively rude health and business remains relatively upbeat, given the tough macroeconomic backdrop. Meanwhile, the service sector is recovering from a severe downturn in the pandemic, aided by improving supply chains. As such, there is growing confidence that the global economy will avoid recession this year and next.
Household demand lies at the heart of this year’s resilience. Spending levels are being supported by buoyant employment levels, exceptionally strong pay growth and consumers choosing to hit the high street rather than to save more. Excess savings built up during the pandemic, and some juicy pay awards, have helped to offset the impact of elevated price pressures. However, the current level of growth in demand seems unsustainable, as savings are further eroded, debt servicing costs soar and unemployment levels potentially pick up.
Unlike consumers, manufacturing has been a notable area of weakness. The level of new orders continues to be very poor, having contracted for an eleventh consecutive month in the US during July1. In addition, the rebuilding of inventories remains low and businesses often face difficulty in obtaining workers, while labour costs are rising.
Traditionally, governments would aim to alleviate some of the economic weakness by spending more. Unfortunately, meaningful state help is unlikely to be forthcoming. Policymakers face high debt levels, rising financing expenses, a bulging number of retirees and the eye-watering levels of investment required to reduce the effects of climate change.
Over the past year, investors and central bankers have been keeping an eagle eye on inflation and any corresponding moves in interest rates. While price pressures have moderated of late, the dip seen in the first half of the year was much smaller than had been anticipated.
Nevertheless, the point of peak-price pressures seems past and the inflation rate is likely to become increasingly digestible. Indeed, headline inflation in the US and the eurozone will probably be back to the relevant central bank’s 2% inflation target by the end of next year. For advanced economies, consumer price increases are forecast to average 2.7% in 2024, markedly more palatable than the 3.9% increase expected for 2023, and the 7.6% surge seen last year.
With moderating price pressures, cooling labour markets and slowing growth, the end of the rate hiking cycle seems to be only a few months away. Central bankers have already indicated that policy levels are restrictive, and have moved from a tightening bias to an approach that is data-dependent. As such, this should encourage them to pause on rates before the end of the year, and eventually pivot to an easing stance in the second half of next year.
Seemingly defying gravity, the US economy surpassed expectations with growth of 2.1% between April and June (quarter two). Upbeat household spending on services, surprisingly healthy export demand and an uptick in both equipment investment and government spending all contributed to the outperformance.
The real driving force behind the economy is the mighty consumer, despite tighter financial conditions. The value of retail purchases increased by 0.7% month-on-month in July2, with the estimates for May and June also revised higher.
However, the consumer seems to be running out of additional firepower. Excess savings are estimated to have fallen from a $2 trillion peak to around $530 billion3. Drawdown rates suggest that these savings are currently being depleted at a rate of $70 billion per month. Demand is also expected to be hit by the resumption of student loan payments. As such, private consumption should average just 0.5% next year, so weighing on growth prospects.
On a more positive note, US inflation is easing quickly. The consumer price index (CPI) for July was 3.2% year-on-year4, compared to a peak of 9.1% last June. Furthermore, June’s CPI was the lowest seen since March 2021. While easing may be harder to come by now, the index is expected to reach 3.1% in the fourth quarter and average 2.4% in 2024.
The US Federal Reserve (Fed) has lifted the fed funds rate by a whopping five-and-a-quarter percentage points since March 2022. The current range, of 5.25-5.5%, is the highest it has been in more than two decades5.
Recent Fed communications have adopted a moderately “hawkish” tone. Chair Jerome Powell reiterated the central bank’s intention to return inflation to the 2% target. Another quarter-point rate hike could follow in November, taking the terminal rate for this cycle to 5.5-5.75%. The next move would likely be around September 2024, with the fed funds rate finishing 2024 at 4.75-5%.
The US downturn looks likely to be skewed towards next year, with growth anticipated at 2.2% this year and 0.5% in 2024.
The relaxing of COVID-19 restrictions, towards the end of last year, was expected to see a rebound in the Chinese economy. After initial encouraging signs, the recovery has lagged expectations. Structural issues hinder the momentum and officials are worried that the world’s second-largest economy looks set to miss its official target of 5% growth for this year.
While the Chinese economy grew by 6.3% year-on-year in Q2, albeit below forecasts of 7.1% and against a period, a year earlier, when Shanghai was in lockdown. The broad-based deterioration in consumption, investment, production and the property sector seems to have continued since June. The labour market has weakened, while credit growth has hit a record low and deflation has returned. Seemingly, a recipe for a slowdown rather than an economic revival.
Concerns about the property sector have grown after bellwether-developer Country Garden missed coupon payments and Evergrande filed for bankruptcy protection in the US in August. In addition, external demand has also come under pressure from the weakness seen in developed economies. Chinese exports slumped by 12.4% year-on-year in June and is likely to retreat in both 2023 and 2024.
In response to the downturn, the People’s Bank of China has cut policy rates and is trying to encourage banks to lend more money. The central bank is forecast to deliver another 10 basis points (bps) of rate cuts in both the final quarter of this year and first one of 2024. Additionally, policymakers might cut the Reserve Requirement Ratio by a quarter point in the first quarter of next year, to try and encourage banks to lend more.
Given the absence of a sustained recovery in consumption, the pain being felt in the property sector and declining external demand, the country will struggle to get close to its 5% growth target for some time. Indeed, economic expansion of 4.5% in 2023, and 4% in 2024, would not be a surprise.
While the eurozone fell into recession (as measured by two consecutive quarters of contracting activity levels) at the turn of this year, many of the economic pressure points have not been as severe as originally feared. In fact, the bloc returned to growth in the second quarter, expanding by 0.3% quarter-on-quarter. Nevertheless, growth is expected to weaken in the second half of this year and through 2024, as rate hikes weigh on consumption, investment and sentiment.
A record low unemployment rate of 6.4% and racy wage growth has not been enough to grow consumer demand. Sales have slumped as European households tighten their belts in reaction to squeezed disposable incomes, rampant inflation and higher mortgage rates. Saving rates have also risen as investors take advantage of enticing interest rates and save more.
Furthermore, the bloc’s retail sales index decreased by 1.4% in June compared to a year earlier. Personal consumption looks set to remain under pressure over the next year as the lagged effect from eurozone rate increases continues to catch up with consumers.
Europe’s capital-intensive industrial sector also continues to struggle. The manufacturing purchasing mangers’ index fell to 42.7 in July, representing the thirteenth consecutive month in which it has been below 506, the point which separates expansion from contraction. The reading shows that manufacturing activity is now back to its lowest levels since pandemic in May 2020.
Helping to lift spirits, inflationary pressures are finally easing. August’s “headline” inflation printed at 5.3%, compared to a peak of 10.7% in October 2022. The softening of price pressures has been helped by base effects and lower energy prices, as well as a broad-based easing in goods and services inflation. As such, inflation, as measured by the harmonised indices of consumer prices, is anticipated to hit 2.5% in December, before getting very close to the 2% target in December 2024.
After the European Central Bank (ECB) lifted rates by a quarter-point in July, this took the deposit rate to 3.75%. A period of stagnation and declining inflation should encourage the ECB to keep rates on hold until the middle of next year, suggesting July’s hike was the last in this cycle. Rates may then fall by a percentage point through the second half of 2024, taking rates to 2.75% by the end of that year.
If not a deep recession, the eurozone still faces significant economic challenges and uninspiring growth of around 0.5% this year, and 0.6% in 2024.
Despite persisting industrial action and annoyingly sticky elevated inflation, the UK economy grew by 0.2% in the second quarter, the strongest quarterly reading in over twelve months. Encouraging private consumption, higher government spending and growing stock levels helped to propel the economy. That said, poor net trade was a fly in the ointment.
While the UK economy will likely expand by 0.5% this year, next year, a general election year, will be little better as gross domestic product nudges up to 0.6%.
One of the reasons for the country’s anaemic growth is the effects of surging pay awards on companies’ bottom lines. Average earnings, excluding bonuses, were up by 7.8% in the three months to June7, compared with a year earlier. While inflated wages ease some of the cost-of-living squeeze, central bankers fear the impact that such pay awards could have on inflation expectations.
There are tentative signs that the employment market may be turning. June’s unemployment rate rose to 4.2%8, the highest since July 2021 and up from 3.5% in August 2022. The rate has further to rise and is expected to finish next year at around 4.5%. Inactivity rates have slowly been normalising and vacancy rates have fallen for 13 consecutive months, although still remain above the one-million mark.
UK inflation continues to sit towards the top of the league among its advanced-economy counterparts. July saw the headline inflation rate ease to 6.7%, helped by softer power prices and a regulatory cut in the energy price cap. Price rises in food, alcohol and tobacco continue to slow due to lower producer prices. For all the positive signs, inflation is still likely to remain well above the 2% target through 2024.
The annoyingly elevated inflation environment is keeping the pressure on the Bank of England in terms of rate moves. The Monetary Policy Committee (MPC) has increased rates at its last fourteen policy meetings, pushing the bank rate to 5.25%, the highest level seen since February 2008.
The MPC has indicated that persistent inflationary pressures mean that more hikes will be needed. A fifteenth straight hike may be on the cards with another quarter point move at its next meeting, in September. That might be the last in this cycle, setting a terminal rate of 5.5%, although that is highly dependent on forthcoming economic data.
Turning to prospects for next year, there is the distinct chance that the central bank could trim rates by a percentage point in the second half of 2024, leaving the policy rate at 4.5% at the end of next year.
While a recession looks like being avoided in the largest economies, an extended period of below-trend growth lies ahead. Activity will remain constrained as the world adjusts to the higher-interest rate backdrop that has followed the pandemic, a disappointing Chinese recovery and further geopolitical tensions.
Weaker Chinese growth than had been expected, and encouraging developments in the US, mean that global growth should expand by 2.7% this year, and 2.4% for 2024, as flagged in Global economy: the good, the bad and the ugly within our Mid-Year Outlook 2023.
Read our latest round-up of the global themes, trends and events currently influencing investors.