Markets Weekly podcast – 5 December 2022

Henk Potts (HP): Hello. It’s Monday, 5^th December and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
 

My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the outlook for fixed income markets. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Equity markets still finished in the green last week, despite some weakness on Friday as risk appetite was boosted by a moderation in eurozone inflation, a winding down of COVID restrictions in China, and a downshift signal from the Federal Reserve.

Last week’s modest gains capped a strong performance for equity markets during the course of November, that’s on hopes that peak inflation is now behind us, the end of the hiking cycle is coming into view, and policymakers can, indeed, orchestrate a softer economic landing, though concerns over aggressive wage inflation, the deteriorating economic backdrop, and the weakening of earnings expectations continue to limit gains.

In Europe, the STOXX 600 surged 6.8% last month, generating the biggest monthly gain since July. European stocks are up 15% since the September lows and delivered back-to-back positive monthly returns for the first time since August 2021.

In the US, the S&P 500 was up 5.4% in November, its third straight month of gains, its longest winning streak since August last year. Hopes of reopening in China resulted in a strong rebound in Asian equities, the MSCI Asia Pacific Index surged 15% in November, its biggest monthly jump since 1998, though the benchmark index is still down 19% compared to the 15% decline we’ve seen on the S&P 500.

The Fed’s policy path continues to be one of the biggest drivers of sentiment. Speaking at the Brookings Institute last week, Jerome Powell appeared to confirm market expectations that the US central bank will slow down the pace on interest rate hikes to 50-basis points at the 14^th December meeting.

That compares to the string of 75-basis point increases they have delivered over the previous four meetings, although the Fed chair continued to caution that monetary policy will likely stay restricted for some time, perhaps in an effort to push back on market expectations that rate cuts could come as early as the fourth quarter next year.

The FOMC is still seeking further tangible evidence that inflation is, actually, declining and labour markets are rebalancing. While inflation has been moderating, US labour market data out last week suggest policymakers will need some convincing that a significant softening is taking place, after the US economy created more jobs than forecast and wage growth surged.

The US economy added 263,000 jobs in November. Consensus, remember, was around about 200,000. October’s figures were revised up to 284,000 gained. The real surprise, remember, came in the wages components. Average hourly earnings rose twice as much as forecast, up six-tenths of 1% in November, the biggest increase since January, and up 5.1% from a year earlier.

Elsewhere, the unemployment rate held steady, at 3.7%, whilst Friday’s report was stronger than expected. As the US economy, I think, continues to weaken through the course of next year, we would expect payroll growth to slow. We’d expect wage growth to soften, and unemployment rates to rise. In fact, we’ve got US unemployment at the end of next year at 4.9%.

Meanwhile, China’s pursuit of zero COVID and the impact on both its domestic economy and global supply chains continues to be a major focus for investors. COVID cases have surged in the world’s second largest economy over the course of the past few weeks. They have now surpassed the levels reported in the second quarter. Remember, that resulted in that Shanghai lockdown.

On Monday last week, for example, the number of daily cases hit a new record, surpassing the 40,000 level for the first time. The social impact of China’s tight restrictions is now starting to come to the fore, with protests breaking out in a number of cities. Officials finally appeared to be bowing to that social unrest by promising to ease mass testing regimes, allow periods of quarantine to be completed at home, also taking action to boost the vaccination rates of its elderly population.

Along with the social impact, the regulations, as we know, have come at significant economic cost. Forward-looking indicators suggest that further risk is to the downside. The National Bureau of Statistics said on Wednesday the official manufacturing purchasing managers’ index fell to 48 this month, which is the lowest reading since April. Manufacturing PMI gauges measuring output.

New orders, raw material, inventories, and employment all contracted in November at a faster pace than the month before, while the non-manufacturing index, which measures activity in the construction and services sector, declined to 46.7 from 48.7 in October, also lower than the consensus estimate of 48. Just to remind you, a reading below 50 indicates contraction.

Moving on to Europe, after 18 months of surging price pressures, November’s inflation print finally offered the moderation that households, businesses, and policymakers have been desperate for. Eurozone inflation eased to 10% year on year in November, which is around four-tenths of 1% below the consensus expectation and the biggest decline since 2020, and compared to that reading of 10.6% in October, which now looks like being the peak. The moderation was driven by falling energy prices, slower advances in services, and base effects, although food prices continued to accelerate, led by processed foods.

In terms of the outlook for eurozone inflation, government intervention in energy markets moderating demand, improving supply chains should allow the inflation profile in the euro area to continue to moderate, although progress back to target levels will be slow. We forecast that euro area inflation will average 5.7% during the course of next year, which we know is keeping at least some of that pressure up on the European Central Bank.

So, that was the global economy and financial markets last week. In order to discuss how investors should be positioned in fixed income markets for 2023 and beyond, I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy, Barclays Private Bank.

Michel, great to have you with us today. Let’s set the scene with where we are. Looking at the Fed, the Bank of England, and the European Central Bank, can you provide us with a brief assessment of how the market’s pricing the respective policy rate path ahead and if this seems realistic at all to you?

Michel Vernier (MV): Yes, of course. Now, all central banks, first of all, seem to face the same problem and the need, of course, to fight excessive levels of inflation. All central banks have responded in a similar way as well, with unprecedented amount of hikes in a short period of time this year as well.

Now, however, underneath the surface it transpires that all three central banks find themselves in a somewhat different situation. And this is the difference which may also lead to some divergence when it comes to the policy and rate environment in the three currency blocs.

Now, first the US. Inflation has started to ease in the last month, from over 9% to now 7.7% in November, and the good news is that goods inflation, the big driver for the previous elevated inflation, is on the decline and sees, partly, even deflationary trends, like in the auto sector, for example.

Now, the ISM surveys lately showed that the survey respondents see actually lower prices in the goods segment as well, that should, actually, lead to lower inflation in that segment. So, higher rates also seem to already be starting to impact the housing market, which has seen lower activity and prices seem to have started to ease, so, another factor which could cause disinflationary trends.

So, overall, it seems to have also triggered that inflation moderation party with rates, and they have come down already, and the reason peaks what the market is pricing in have also been lowered as well. The current forward curve implies a peak at short of 5%, coming from around 5.5% previously. Now, while we agree with the trend of moderating inflation, we see, also, some surprise potential, especially in the US.

Now, the Fed is concerned about inflation becoming entrenched and it has only one thing in mind here. It’s the US employees asking for higher wages. Now, the New York Fed’s October survey of consumer expectations for inflation, for mean inflation, that has increased now to an all-time high, to 5.9% from 5.4%, and that’s not good news for service inflation, apart from housing and shelter costs.

Now, the job market in the US remains very tight and the Fed is keen to change that, and if the job market proves to be too sticky, the Fed will have only one response, which is higher rates. As such, we see some potential that the market, over time, may price back some hikes towards 5.25%, perhaps from the 5%. Now, maybe even 5.5%. But, most importantly, however, the Fed is trying to keep rates higher for longer. That’s what they have already indicated, and potentially lower than the market expects.

Now, given there’s still the potential for significantly higher rates, that seems to abate. We see an environment which should be constructive for fixed income in the US. Now, in the UK and Europe, we see a slightly different situation, as the respective economies show greater vulnerabilities. Now, this in turn, this leads us to our view that the rate market currently may overstate the current peak in policy rates.

Now, in the UK, for example, it’s a very weak consumer combined with a decelerated savings ratio, record low real income, so adjusted for inflation, and the housing market, of course. Now, true, the pressure with regards to inflation in the UK seemed to be very high. Recent inflation data has increased even from 10.1%, to 11.1%, but equally the UK currently may already find itself in a recession, as recent negative GDP data has shown. Now, the mortgage market will have an additional negative impact on the UK consumer, and this negative feedback loop will also lead to that weaker UK, you know, economic backdrop.

Now, according to the market, the BoE base rate is expected to peak at well over 4.5%, and we’ve already been quite sceptical about that pricing and also if the BoE really has the room to go far beyond 3.5% or 4%, which we actually see as more realistic at this point of time, which means that we prefer to lock in rates now by focusing on medium-term bonds before rates coming down even further.

Now, very quickly, to the ECB. Now, obviously the ECB is keen to act swiftly. Now, after inflation data, ECB members commented that the latest inflation outcomes were not all reassuring. We have seen that inflation data have moderated a bit, but core inflation is still very sticky.

However, again, you know, we have the vulnerabilities in the economy. Higher energy costs mean also a deterioration in the outlook for the EU economy, and the central bank may, actually, lower the pace now of hikes, maybe around 50-basis points in December, but then the market is already pricing something like 2.8% by June next year and even that we see actually quite ambitious. We see -1% growth over 2023, and that may actually lead to the fact that the ECB may not go all the way towards that level.

So, again, the markets may overprice in the EU, maybe in the UK as well. We may see a bit of potential for higher rates in the US, but, overall, not too much. So, the market seems to kind of be a bit over-reacting with regards to that. So, they still see potential for lower rates, specifically in the UK and EU.

HP: OK. Let’s try and bring that all together and think about what it means for investors. If we expect policy rates to peak only next year, with the risk of even higher rates, especially in the United States, investors may be tempted to wait for such a peak before going into fixed income. Would you recommend that?

MV: Yes, you know, we get this response, actually, quite a lot. I mean why investing now if, a) we even would expect higher rates to come in the next year and the risk, as you just mentioned, of higher rates if inflation is coming, is not coming down that quickly.

Now, first of all, what we need to take into account here is the market is already pricing the future, and so if we are talking about the market is pricing in a peak, then an investor who invests now, in let’s say two- or five-year bonds, is already capturing that peak, you know, this is a forward-rate calculation and not kind of the average coupon or yield you would get over time. So, you know, by investing now you’re already capturing that priced-in peak today.

Now, the other thing what we need to take into account is, you know, what is the price today may not be priced-in tomorrow, because, as we have seen, you know, two weeks ago the rates market had actually priced in a much, much higher peak, and now it’s coming down already. So, you know, the rate market is also not sticky, it’s quite an evolving target, a moving target, and, you know, we may see actually now that phase of the disinflationary party, what I’ve just mentioned, you know, markets celebrating that the Fed, the ECB, and the BoE may not go that far and the disinflationary trend may actually accelerate over the next month or so, just because of these temporary factors of inflation may come down on the good side, which is good news, obviously, but it also means lower rates.

Now, again, there might be a risk of higher rates in the future, but we’re not entirely sure. So, let’s say if that moderation path is actually going to continue in a fairly forward straight line, then we may have already seen the peak in rates. We’re not saying that’s set-in stone, but, you know, that might well be a missed opportunity if investors are just waiting for higher rates and they’re not coming back at all.

So, you know, investing at around 5% or 5.5% investment rate bonds, depending on the markets where we are investing in, and in Europe it’s maybe a bit lower, but it actually secures you to these higher rates rather than waiting for base rates or cash rates to come down again when the EU, UK, and the US central banks need to cut rates again.

HP: Thank you, Michel. So, bearing all of that in mind, where do you see the risk to our call to lock in yields now?

MV: Yeah, I mean as we already mentioned, the biggest risk is obviously that inflation may not abate that quickly. There’s uncertainty around the energy situation in Europe, you know, we also may have a very sticky and robust job market in the US and while the recessionary pressures increase, especially in the US, the US economy may prove to be even more robust and stable growth may not lead to a rapid moderation of inflation, and they may then actually need to react further by adding more hikes, as already mentioned.

Now, the greater risk, however, we see in the US, that the market has already mentioned that the market is underestimating the length of period of higher rates. So, as I said, the market expects that we may see some cuts coming into 2024, but there’s a greater risk that we see a longer period of higher rates, but we don’t see necessarily the biggest risk that yields are going to be much, much higher in the UK, and even there’s only limited upside in the US.

So, that is a risk that, I’m going to say a longer risk, but then coming back, you know, investors have then two options, wait for that risk to materialise, that we may see some higher rates, so let it be kind of 50-basis points higher, but that actually compares to the risk of not locking in rates and that we actually may see a much, much lower peak in all central bank rates, of let’s say 50-, or even, you know, 75-basis points, and then you would have a missed opportunity and that’s proved sometimes to be more expensive than anything else.

HP: Well, thank you, Michel, for your insight today. After a decade or so in the wilderness it’s imperative, I think, that investors really do need to appreciate the new opportunities across fixed income, as well as understanding the important role bonds will once again play within a diversified portfolio.

Let’s move on to the week ahead, where, in fact, it will be a bit of a quiet week from a data perspective. In the US, the focus will be on the ISM prints on Monday and Friday’s PPI figures. We expect the ISM service composite to remain in solid expansionary territory in November at 54, following October’s 54.4 reading.

This would be in stark contrast to the ISM manufacturing composite released last week, which showed factory activity slipping to a sub-50 reading for the first time since the lockdowns in 2020. We expect detailed indices for input prices and delivery times to continue to show stubbornly tight supply conditions in the service sector, again, in contrast with the signs of sharp easing on the goods side seen over the course of the past few months.

We forecast a headline PPI increase of one-tenth of 1% month on month, 7.1% year on year in November. The deceleration we expect in that headline figure is due to declining oil prices throughout the course of the month.

With that, I’d like to thank you once again for joining us. I hope that you found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.