Markets Weekly podcast – 3 July 2023

Henk Potts (HP):  Hello. It’s Monday, 3rd July 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. 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 consider the question of ‘de-dollarisation’. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead. 

Equity markets closed out the first half of the year with strong gains as technology stocks continued to defy the forces of gravity, but strengthening economic headwinds, lofty equity valuations and attractive fixed income yields suggest the second half could be a different story. 

The S&P 500 rose 2.3% last week and was up 8.3% in the second quarter. The benchmark index was up 16% in the first half, the best start to the year since 2019. The gains, as we know, have been driven by mega-cap technology stocks. The Nasdaq gained 31.7%, its best first half in 40 years.  

Equities in Europe also put in a strong performance over the first half but have lagged behind US markets due to a lower technology rating and evidence of faster deterioration in activity. The STOXX 600 rose 2.3% during the course of last week. It was up 8.7% year to date. 

Why do we question the sustainability of the rally? Well, investor sentiment has been boosted by resilient economic data, but we are expecting a bumpy landing for the global economy in the second half of the year, as the tailwinds from robust labour markets, vigorous consumer spending, the service sector recovery and the benefits of China re-opening start to fade. 

We know that peak interest rates will be higher than previously projected. The interest rate hiking cycle is expected to be extended into the second half of the year, and the lagged impact of previous hikes will increasingly filter through to household consumption and corporate investment. 

We should also appreciate that the rally has been driven by a very narrow group, specifically in that AI space. Investors may question how quickly the technology revolution will translate into earnings growth. And, of course, equities are facing greater competition from fixed-income assets, where rising rates have been boosting yields. 

Moving on to the macro side, as we have been discussing, US economic activity has proved to be more resilient than expected since the start of the year. In fact, first-quarter GDP was revised up to a better-than-expected 2% annualised rate, helped by upward revisions to consumer spending and exports. Household spending, which we should remember accounts for 70% of activity in the US economy, rose 4.2% in the first quarter. That’s the strongest pace in two years. Exports rose 7.8% quarter on quarter. 

However, when you start to look at the more recent PCE May data, that does provide some evidence of a slowing consumer momentum over the course of the past couple of months. Consumer spending rose just 0.1% in May, and April’s growth was revised lower.  

The easing back of demand filtered through to price pressures. Headline PCE inflation slowed to one-tenth of 1% month on month, following that 0.4% increase in April. The annual rate slowed to 3.8%. That’s the smallest increase since April 2021, helped by base effects from energy prices. Core PCE inflation also moderated and came in at three-tenths of 1% month on month, amid softer core services inflation. 

So, taking into account the recent data releases, we now see the US economy growing at 1.5% in the second quarter, after which the slowdown, I think, starts to really shine through, with activity stagnating in the third quarter and then contracting from the fourth quarter through the first half of 2024. So, we still see a shallow, technical US recession playing out through the turn of the year. 

In Europe, the focus was on Friday’s June inflation report, where price pressures eased to 5.5% last month compared to 6.1% in May, back to its lowest level since the start of last year, as energy inflation continued to ease, driven by lower wholesale energy prices, which are progressively feeding into consumer prices.  

When you look at food, alcohol and tobacco inflation, well, actually, it came in above expectations at 0.4% month on month, 11.7% year on year, although still decelerated compared to where we were back in May. And services inflation rebounded after a technical dip in May, but was much less than was projected. There’s very little evidence of a seasonal acceleration. 

In terms of the outlook for euro inflation, we think headline CPI will be below 3% by the time that we finish this year and close to that 2% target level at the end of 2024, which should take some of the pressure off the European Central Bank, although we still expect the ECB to push ahead with a 25 basis point hike at the July meeting, but that could well prove to be the end of this hiking cycle. 

Moving on the UK, despite some subdued mortgage activity, house prices continued to demonstrate resilience. The June Nationwide house price index ticked up one-tenth of 1% month on month, having fallen three-tenths of 1% quarter on quarter during the course of the second quarter, although the annual decline of 3.5% was still the highest since 2009. 

The lender said that the sharp increase in borrowing costs is likely to exert a significant drag on the housing market activity in the near term. Remember, in the UK there are around 10.5 million residential and buy-to-let mortgages. 8.2 million of those are on a fixed rate, 800,000 fixed-rate deals reach the end of their product term during the course of this year, then another 1.6 million in 2024. 

UK house prices peaked in August last year and are down 4.1% from their peak. Our internal forecast suggests that UK house prices should not generate a peak-to-trough decline of more than 10%. The market, we think, should remain supported by a steady labour market, which is helping people to service their mortgage payments.  

Banks have been stress-testing mortgage applicants at a higher rate, so affordability will actually be less of an issue than we’ve seen in previous cycles. There continues to be a real structural supply-and-demand imbalance for UK houses, and we also know international demand continues to be positive. 

So, that was the global economy and financial markets last week. Now, let’s turn to the topic of de-dollarisation. It’s a subject that’s actually been around long before I started my career in financial markets but has come to the attention of investors once again, particularly after the United States excluded the Russian central bank from the dollar system, thus weaponising the dollar, and some commodity exporters are exploring alternatives to the dollar as well. 

So, lots to consider on this one. I’m fortunate to be joined by Lukas Gehrig, Quantitative Strategist at Barclays Private Bank, to discuss the future of the US dollar. Lukas, great to have you with us today. Before we get into discussing the potential end of the dollar’s reign, what does the global reserve currency status actually mean to the US and the rest of the world? 

Lukas Gehrig (LG):  Well, Henk, it’s great to be back. Thanks for having for me. Looking at the US, a few things come to mind, for example, frictionless trade. As a US producer, not having to acquire dollars in order to make your purchases for input goods, that’s a huge burden off your back, and that’s actually a task that can be difficult for many emerging-market producers these days. 

Other than that, we have some form of balance-of-payments flexibility. That means that the US is able to pass on the inflationary costs of domestic spending and military expenditures to others. And then, there’s one point that is often overlooked. It is political autonomy. The US doesn’t have to worry about being excluded from the dollar system like others have this year, and many of these things have been taken for granted. 

And, I believe all the listeners of this podcast will probably be ‘dollar children’, so they have never experienced another regime. And what can this loss of a global currency status actually mean? Well, nowadays, this can only be guessed at from the history books from the decline of the British Empire. 

HP: OK. So being the global reserve currency is clearly a considerable advantage and a privilege. Do you think that this privilege is about to run out? 

LG:  I think we have to understand what a currency really needs to fulfil in order to be a global reserve currency. And, in terms of economics, there’s three functions of money that this currency has to fulfil on a global scale. It has to act as a store of value, a means of exchange and a means of accounting. 

Now, the dollar clearly does fulfil all these still, but the problem is so do others, like, for example, the euro. We believe that the dollar will stay as King Dollar, but for different reasons than before. 

Now, it’s not the sheer size of the US economy anymore. The US economy is around 25% of the world’s GDP. It used to be much more than that. It’s also not trade invoicing alone, so the dollar is still the dominant currency in commodity trade, but there are entire regions, like, for example, the eurozone, whose inter-region trade doesn’t depend on the dollar.  

It’s not military power either. While no country spends even half as much as the US on military spending, we believe that over the last year we have seen that even a superpower will have trouble controlling a multi-crisis world, as the one we may be in right now. 

So, what is it then that is upholding the reign of the dollar? We believe it is the US capital market. No other market has the depth and the liquidity that the US does. So, for example, in terms of equities, close to 40% of global equities are issued in the US. And, if you look at bonds, it’s even over 40% of global bonds. 

If you further restrict this to only look at AAA-rated debt, then the US almost has a monopoly. The US issues over 80% of world government bonds at an AAA rating. So, in a sense, you could argue that the US debt has become a global commodity that everybody wants to buy, especially during a slowdown when market participants are looking to de-risk their portfolios. 

What are they going to buy? Well, they will need dollars to buy that. So, we believe over the past that institutions, like, for example, Bretton Woods or the petrodollar agreements, they have given the US dollar system time to grow, such that now it is less reliant on those explicit institutions than it used to be. 

HP:  Lukas, it’s certainly interesting to consider debt as a commodity, but doesn’t that also raise the stakes should something go wrong? 

LG:  It’s definitely a double-edged sword, as you say. So, the US debt is around 124% of GDP. It used to be just 55% two decades ago, but this only really becomes a problem once the US dollar loses its dominant global position. And, for now, there is no challenger in sight on the capital-market front. So, the eurozone is disorganised when it comes to bond issuance, and China still has this closed-off capital market that is super difficult to invest in. 

HP:  OK. Let’s add a modern twist to this old debate. What about challenges from the digital realm? Could bitcoin at some point replace the dollar? 

LG:  I think we have to answer this modern twist going back to theory, and let me take you back to these three functions of money which a global reserve currency would have to fulfil. So, we know that cryptocurrencies can be a means of accounting. Sometimes they can even be a means of exchange. So, I heard that you can purchase on the Microsoft Store with bitcoin these days. But, when it comes to a store of value, it still gets difficult. With an annualised volatility north of 50%, I wouldn’t call bitcoin, for example, a good store of value these days. 

In general, I believe that a scarce commodity, whether it’s digital or not, is not flexible enough to accommodate the bubbly nature of our modern economies. However, a digital fiat currency, that is backed up by a government, like the one that is being currently explored by China and Russia, that could be appealing to actors in economies that fear getting on the wrong side of the US and, so to say, having the US dollar rug pulled out from under them. 

HP:  So, the dollar will remain the global reserve currency, but competitors are on the move. What implications does this have for investors? 

LG:  Well, it depends. If you’re a European investor then you are in this extended US dollar nexus. Your trade invoicing is predominantly in euro, but when it comes to investments, your pension fund etc, you are bound to the dollar, and that is unlikely to change soon. 

If you’re outside this influence zone, then trade invoicing may slowly shift away from the dollar, but the hold of the dollar on global commodity trade is immense. You know, these petrodollar agreements, they worked for a reason, because they gave the commodity producers a store of value for their proceeds. 

When it comes to the dollar itself, well, it has shown itself to be the biggest of safe havens over the last year, and this is not going to change. Structurally, over the longer term, the dollar should resume its downward trajectory once the economy hits its trough though. 

HP:  Well, thank you, Lukas, for your insights today. We know that de-dollarisation is certainly a question that is consistently asked by clients, so it’s great to get your perspective on the current status, the possible long-term trend, as well as those investment implications. 

Let’s move on to the week ahead, where we expect the US economy to have created 225,000 jobs in June, down from the 339,000 in May, when we get the nonfarm payroll figure on Friday. We expect the average hourly earnings to maintain the pace seen in May, rising three-tenths of 1% month on month, 4.2% year on year. 

When it comes to the household side of the report, we expect the unemployment rate to decline to 3.6%, the participation rate remaining constant. We also get the latest updates regarding job openings, the quits rate and the hiring rate, from the May jobs survey. We think that job openings likely declined relative to April’s reading, coming in at 9.7 million versus 10.1 million openings seen in the prior months. So, markets will be certainly focused on those labour reports as we go through the course of this week, and, of course, implications for Fed policy. 

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