Markets Weekly podcast – 4 September 2023

Henk Potts (HP): Hello. It’s Monday, 4th September 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 how investors should be positioned in fixed income markets. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

It was a positive week for equity markets last week as investors reacted to the US employment report that adds to the evidence of a policy pause in September, robust US consumer spending in July as wages rise and savings rates decline, and further policy support from China, accompanied by hopes that its manufacturing sector has bottomed out after unexpectedly returning to expansion in August.

The S&P 500 was up 2.5% over the course of the week, its best weekly performance since the middle of June. In Europe, the STOXX 600 closed up 1.5% over the course of the week. 

But this week, I’ll take a bit of a step back from the melees of the markets to give you a brief overview of the macroeconomic updates that forms part of this month’s Market Perspectives. 

Within the article, we highlight our latest economic projections. We assess how well policymakers have been doing with the battle with inflation in trying to avert the risk of a recession. Then, as usual, we take readers on a whistlestop tour of the global economy, looking at some of the major regions from a growth, inflation and path-of-policy perspective.

So, I thought I’d share some of those insights with you today. You can, of course, find those on the Barclays Private Bank website.

We start off by saying economists should be forgiven for predicting that a recession would occur in 2023. At the start of the year the apparently toxic combination of multi-decade high inflation, the steepest rate-hiking cycle since the 1980s, coupled with the ramifications of the war in Ukraine and rising trade tensions, all pointed to an inevitable contraction in economic activity in the US, Europe and the UK.

So, why no recession? Well, consumers have been spending at a far better rate than expected this year. Labour markets have remained in relatively rude health. Business sentiment continues to be relatively upbeat, given the tough macroeconomic backdrop. Meanwhile, supply chains, as we know, have significantly improved and the service sector is recovering from that severe downturn during the course of the pandemic. Therefore, confidence that the global economy will avoid a recession this year and next has grown.

Household demand lies at the heart of this year’s resilience. Spending levels are being supported by buoyant employment numbers, exceptionally strong pay growth. Consumers have chosen to spend more of their income rather than just save it. Excess savings built up during the course of the pandemic and some juicy pay awards have helped to offset the impact of elevated price pressures.

However, we think that the current level of consumption growth is unsustainable as savings rates are further eroded, debt servicing costs soar and unemployment starts to pick up.

In terms of weakness, well, manufacturing has been a notable area of concern. If we look at the level of new orders that continue to be very poor, the rebuilding of inventories remains very low, input costs, as we know, have surged over the course of the past couple of years, and businesses are facing real difficulty in obtaining the workers that they require.

Global manufacturing PMI data has tumbled over the course of the past year, slumping into contraction territory. Now, traditionally, governments would aim to alleviate some of that economic weakness by spending more. Unfortunately, meaningful fiscal support is unlikely to be forthcoming as policymakers face up to high debt levels, rising financing expenses and, of course, the bulging number of retirees. They will also, of course, face up to the eyewatering 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 interesting rates. Our expectations were, at the start of the year, that price pressures would moderate. Progress in the first half, you have to say, was slower than expected. Food prices rose, energy remained elevated, and wage growth shone through.

Nevertheless, over the course of the past few months, prints have moderated, helped by base effects. We do think that we’re past the point of peak price pressures. We do think that inflation rates will continue to become increasingly digestible. Indeed, headline inflation is forecast to head back towards central banks’ targeted levels by the end of this year in the US and in Europe.

To put some numbers around the global picture, we expect global CPI to average 2.7% in 2024, markedly more palatable than that 3.9% increase expected for this year and that 6.3% surge that we saw during the course of 2022.

In terms of the path of policy, moderating price pressures, cooling labour markets and slowing growth have encouraged us to call the end of the rate-hiking cycle over the next couple of months. Central bankers have already indicated that policy levels are restrictive and will move from a tightening bias to an approach that is data dependent in many regions.

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 2024. So, in terms of a summary of the economic outlook, while a recession looks like being avoided in the largest economies, we should appreciate that an extended period of below-trend growth lies ahead. Activity, we think, will remain constrained as the world adjusts to the higher interest rate backdrop that’s followed the pandemic, the disappointing Chinese recovery and further geopolitical tensions.

However, weaker-than-expected Chinese growth should be balanced out a little bit by some of the more encouraging developments that we’ve been seeing from the United States. Therefore, we see global growth being around 2.7% during the course of this year, then easing back slightly in 2024, coming in around 2.4%.

So, that was the global economy and financial markets last week and our expectations for the economic outlook. In order to discuss opportunities in bond markets, I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank.

Michel, great to have you with us today. Let’s start by considering the current environment. The Jackson Hole Policy Symposium has set the tone for rate markets. What did we learn from those keynote speeches from central bankers, and how have markets reacted?

Michel Vernier (MV): Yes. Hello, Henk, and hello to our listeners here on the podcast.

As you said, the Jackson Hole speech in late August by Jerome Powell was highly anticipated, but it did not deliver any major change in direction or tone. The Fed chair reiterated the central bank’s stance that the period of high inflation has not vanished yet.

Fed chair Powell said that, although inflation has moved down from its peak, a welcome development, it remains too high. ECB President Christine Lagarde, meanwhile, seemed to sing from the same hymn sheet as Powell, as she said that while progress has been made, the fight against inflation is not yet won. And she also said that the ECB would not lose sight of its target and must, and will, keep inflation at 2% over the medium term.

Now, interestingly, both have firmly stated that this 2% inflation target will not be compromised. The rate market reacted with some relief, but there continues to the possibility of some more rate hikes in the near future.

HP: Over the course of the past year the great debate, as we know, has been around identifying the point of peak rates. Can we now finally say that we’re truly approaching that point? If so, what does that mean for investors?

MV: Yes, again, let me read out what Powell said with regards to the Fed’s intention and with regards to further hiking. Additional evidence, he said, of persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy.

Now, the good news is that inflation in the US has retreated, as you said, from the peak at 9.1% to now 3.16%, so we can clearly say that the period of excessive inflation is behind us. But, more importantly for the Fed, core inflation, which is less volatile and reflects more the trend of the long-term driving forces of inflation, is still well above the target of 2%, at 4.7%. And if you take the PCE preferred measure of the Fed, it stands at 4.2%.

Now, the Fed has repeatedly reiterated that the biggest driver for core-service inflation is wage growth. Now, while the labour market remains tight, the positive news is that lately we have seen some signs of easing within the labour market. We’ve seen this in the non-farm payroll numbers on Friday, and we may get some further direction from the Atlanta wage-growth tracker as well.

Now, this, in turn, means that the Fed is not far away from the peak. We should not rule out another 25-basis point hike towards 5.75%, but even the hawks would now settle for such a level at this point. So, you can see that we’ve come a long way and there is a much stronger consensus between hawks and doves when it comes to the peak rate than was seen six or 12 months ago, for example.

Now, in the eurozone, we also seem to have arrived at the very late phase of the hiking cycle and perhaps have already seen the last hike. But underneath the surface, it seems that the eurozone is on a different path compared to the US. IMF chief Kristalina Georgieva has pointed to this phenomenon.

We’re going to see, after a period of convergence in monetary policy action, tightening rates, fighting inflation, some divergence as, for instance, the US economy grows faster than the European Union. That’s what she said last week in an interview. 

So, weak PMI data in the eurozone points to a severe slowdown which, in turn, puts the bar for further hikes substantially higher, compared to the US, in our view. In fact, given this, and that the eurozone economy potentially seems in a much weaker foundation, it may lead to earlier cuts than in the US.

Now, in the eurozone, we would be quite constructive to take on duration, for example, medium to even selectively longer bonds as long as yields are higher.

Now, when it comes to the base rate in the UK, we believe that 5.5% seems reasonable, but we have to consider that the BoE has to make harsh compromises and may even add another hike.

So, what is the take of the BoE? Now, BoE chief economist Huw Pill last week referred to Table Mountain in Cape Town, when it comes to the projected base-rate path. So, no excessive hikes from here, but rather a higher level-for-longer.

Economic data so far have not been as bad as initially feared and inflation remains worryingly sticky. This, in turn, may lead to higher rates for longer in the UK. But still, clouds on the economic front are emerging with higher mortgage rates and persistently high inflation. 

The consumer will increasingly feel the headwinds and, we think, the pain has not hit the consumer in its full force yet. So, even in the UK, higher-for-longer should not be confused with higher forever.

HP: Michel, you’ve mentioned a little bit about this, but we know that yields are high but so is inflation. From that perspective, you could argue that bonds still don’t look very appealing. What is your message to bond investors?

MV: Absolutely, you’re right. I mean, in times of high inflation, higher yields after all may not appear as attractive. It should state on every ‘tin’, returns can be eaten up by inflation.

But, look, we have had almost a decade of low inflation, but at the same time we also had even lower rates. So, negative real returns or negative real yields. Now, after the magnitude of rate hikes in the US, the real policy rate is at around 0.8%, adjusted for core inflation. The last time we saw that level, was in around 2009. 

Admittedly, it still does not sound very appealing for two reasons, and the 0.8%, however, is not really relevant for bond investors. First, the policy rate drives short-term cash rates and moves while bond investors usually invest in three- or five-year bonds or even longer ones. Secondly, the 0.8% was based on past inflation and core inflation is unlikely to stay at the current rate of 4.7%. Late-July data showed a run rate consistent with around 2.5%, by the way.

Now, this, in turn, means that an average-to-real inflation-adjusted return or realised yield will be potentially higher for bond investors. Now, the inflation-linked bond market, where real yields effectively can be locked in, shows a five-year real yield of 2.2% in the US. That’s the highest level since the Great Financial Crisis in 2008.

So, while real yields may not seem as appealing they, in our expectations, are seen as, within the inflation-linked bond market in the US or TIPS markets, effectively higher. 

So, we acknowledge that inflation is high. History has shown, however, that at point of high inflation, peaking inflation, effective real yields are high, supported by higher nominal rates anchored through high prevailing inflation at that point but then supported by a disinflationary trend. So, lower inflation over the subsequent period effectively provides higher real yields. 

So, having said this all, we do indeed believe that even from a real, so inflation-adjusted perspective, locking in yield does seem a reasonable strategy today.

HP: Well, thank you, Michel, for your insight today. We know it’s been a turbulent time for bond investors, so thank you for adding some clarity around where we are. The key market forces are, most importantly, how investors should be positioned.

Let’s move on to the week ahead, where the focus will return to China’s struggling recovery, with economists expecting another round of weak trade and inflation data. External demand for Chinese products has come under pressure from reduced demand from developed economies. Imports are expected to have contracted once again in August, with the ongoing disruption in the property sector reducing demand for building materials.

Whilst the rest of the world has been preoccupied by surging inflationary pressures, weak demand has seen China battling deflation. CPI, remember, fell three-tenths of 1% year-on-year in July. It’s the lowest that we’ve seen since January 2021. The producer price index declined 4.4% year-on-year.

Investors will be anticipating another weak reading, keeping pressure on policymakers to provide further stimulus.

In the US it’s a quiet week, with the Labor Day holiday on Monday, but on Wednesday, we get the most important datapoint of the week, the ISM survey of activity across the services sector, which is expected to remain in expansion territory at 52.5. On the same day, investors will be looking for a snapshot of the US economy with the release of the Beige Book.

In the UK, we expect final PMIs to print in line with their flash estimates. Within the details, we’ll be looking to see whether the final release revises away the encouraging increase in the services output price index.

With that, we’d like to thank you once again for joining us. We 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.