MacroScope
Those expecting central banks would deliver a pre-Christmas pivot were left empty-handed last week as a toxic mix of tighter policy and the promise of further rate hikes hit the two largest economic regions of the world. Support for swollen fiscal deficits is being withdrawn leaving private investors to step into the breach with increased bond purchases, sucking the liquidity from other asset classes. Last week’s packed economic agenda had a significant impact on markets and warrants careful review as the year draws to a close, with little improvement in the challenging outlook that has hung over markets since the year began.
In the US, November’s increase in the core Consumer Price Index of just .2% was a tenth below expectations and the smallest since August 2021, but this second consecutive month of easing core inflation had little influence on the outcome of the FOMC meeting.
Overbuilt retailer inventories and an increasing supply of new and used vehicles are leading to outright price declines in those sectors, while energy inflation has plunged from over 40% in the summer to 8.5%, and without another crude price spike, will turn negative early next year. Slower price increases for newly signed leases will feed through to shelter inflation after a lag, but Powell emphasised the more stable trend in services inflation. Excluding shelter, this represents 55% of the CPI and remains a concern, with Powell pledging to keep hiking to reach a “sufficiently restrictive” policy stance. The Summary of Economic Projections supported this hawkish outlook, with higher projections of PCE inflation over the next two years being met with higher fed funds rates.
Sifting through the heavy schedule of recent US data releases reveals a slowing pace of economic growth has but no sign of a nosedive. Retail sales in the Control Group were disappointing in November but that followed a robust .5% increase in October, and real consumption in Q4 is likely to grow at a solid pace between 2% and 3%. Jobless claims remain low and labour demand still exceeds supply, but Friday’s S&P composite PMI for December was decidedly downbeat, with an almost 2-point decline to a four-month low of 44.6. According to S&P, this latest level of the PMI corresponds to a fourth quarter contraction at a 1.5% annualised rate, which is almost certainly overly pessimistic. The latest Atlanta Fed GDPNow model takes account of the drop in retail sales and still forecasts growth at a 2.8% annualised rate.
European investors were dealt a harsh blow by the most hawkish ECB press conference in at least a decade, with its inflation projections lifted across the forecast horizon and the introduction of the 2025 outlook showing inflation still far above target at 2.3%. After hiking 75bps in September and October, the pace was slowed to 50bps, but the outlook called for a higher terminal rate, and Lagarde’s pledge to “raise interest rates at a 50 basis-point pace for a period of time” was taken to mean at least two further similar hikes in February and March.
According to “sources” more than a third of ECB officials favoured a 75-basis point increase, and Governing Council members that spoke on Friday rammed the message home, piling further pressure on European fixed income. French central bank Governor Villeroy said that market rate expectations fell too far in November while Austria’s Robert Holzmann said the ECB is ready to take rates deep into restrictive territory. Finland’s Ollie Rehn was clear that “50 basis-point rate hikes” are likely “in February and March” while Madis Müller of Estonia – where inflation is currently 21.3% - said the ECB will push rates “probably higher than the financial markets have expected so far”.
Recent European economic releases have pointed to a more promising outlook, with institutions like Germany’s IFO and IfW back-peddling on their previous predictions of a deep recession from an intensifying energy crisis. The FT last week reported that natural gas consumption in Europe during October and November was a quarter less than the five-year average, and storage tanks are still roughly 20% above normal levels for this time of year, despite almost no Russian gas being delivered. Friday’s S&P composite PMI for the Eurozone rose a point to 48.8, with a slowing rate of new order declines, lower price pressures and improving business confidence. According to S&P, fourth quarter GDP will likely contract at a quarterly rate of ”just less than 0.2%”, while forward-looking indicators suggest the rate of decline will “ease further in the first quarter”.
The Bank of England also eased off the brakes with a 50bps hike after a single move of 75bp in November, but its divided three-way vote reflected a committee with no clear sense of direction. When inflation first pierced its 2% target over 18 months ago with stimulus still in full flow, the Bank delayed tightening before moving at a snail’s pace that has left it rudderless in a tempest of double-digit inflation. Five former members of the MPC spoke at an event on Friday hosted by Fathom Consulting and Chatham House where they ridiculed the latest “implausible” BoE forecasts published alongside the rate decision which they found “unbelievable”. Charles Goodhart was clear that expecting to “hold inflation down when holding interest rates at 3%” is not only implausible – “It’s crazy. What model is that based on?”
UK data on Friday included retail sales for November which appeared worse than expected with a .4% decline in real terms, although the November reporting period was only till 25th November - capturing Black Friday but leaving Cyber Monday sales in December’s figures. According to the ONS, non-seasonally adjusted sales rose 11.4% in November but were adjusted to a .4% decline.
The November S&P composite PMI for the UK unexpectedly improved almost a point to a three-month high of 49 with services recovering to 50 from a mild contraction, while manufacturing sank further to 44.7. S&P noted “the downturn looks to be relatively mild, and the easing in the rate of decline in December is encouraging” but the “sustained rise in price pressures will pour fuel on the fire of squeezed business margins”.
Markets
Powell’s press conference highlighted the Fed’s resolve to avoid calling a premature victory in the inflation battle, despite rapidly easing goods price inflation. Wages comprise the largest cost of providing services, and with labour still in short supply across most of the G20[1], pay growth has shown little sign of slowing, explaining much of problem in curbing service-sector inflation – a problem that is not unique to the US.
The Atlanta Fed wage growth tracker shows that for the past three months US wages have been growing at around 6.4% annually, but with the demand for labour still outstripping supply by a historically wide margin, firms are competing to hire and retain staff by offering higher rates of pay. There are simply more available jobs than the size of the workforce i.e. those currently working and those looking for work.
The Fed is trying to cool this labour demand and believes policy should be much tighter. Nineteen officials - comprised of the seven Board governors and all 12 regional voting and non-voting members - contribute to the DOT plot by each indicating their expected fed funds rate at the end of the years in the projection. The DOT plot that accompanied September’s Summary of Economic Projections showed not a single member expecting a fed funds rate above 5% over the whole forecast horizon, but at last week’s meeting only two of the nineteen officials expected next December’s rate to be below 5%. Ten expect a year end rate of 5% - 5.25% and the remaining seven projected even higher rates.
Markets expect a rapid decline in headline inflation (according to inflation swap pricing) and show total disbelief in the FOMC’s rate projections, as fed funds futures currently price cuts beginning in June from a peak rate of 4.85%.
Despite this diverging opinion on the profile of future rates, the market price of inflation swaps falls rapidly to 2.4% over the next few months, so that real rates are expected to turn positive by April. The yield on two-year TIPS of 1.56% reinforces this expectation that the real fed funds rate will soon be positive - either by inflation undershooting the Fed’s projections or rates climbing in line with them.
When the Fed took real rates positive at the end of 2018 after almost a decade of stimulus, the equity market threw its toys out the pram, and the deeply negative rates during 2021 propelled all assets. Regardless of inflation forecasts, an average real positive rate of 1.35% can now be guaranteed for the next ten years by buying a ten-year TIPS – leaving equity valuations vulnerable based on the historic relationship. Two weeks ago - when hopes for a Fed pivot were riding high – the ten-year TIPS yield was at 1.05%, and the 30bps increase since then has weighed on markets.
The EU is also now taking a tougher approach to tackling its double-digit inflation, with the ECB’s explicit guidance driving expectations of next year’s rate hikes from a total of 80bps before the meeting to roughly 120bps, while quantitative tightening will start at a pace of €15bn/month in March. Looser fiscal policies to combat the energy crisis means that debt issuance will go from €1.1 trillion to €1.3 trillion next year, and with the Asset Purchase Program being scaled back, net purchases by private investors will need to rise from €200bn to roughly €400bn. Finding enough private investors to soak up the additional supply will require higher yields, and last week’s 46bps jump in the ten-year BTP yield may be a taste of things to come.
Fixed income markets elsewhere in the G7 are also vulnerable. The BoE runs the risk of upsetting the long end of the gilt market with its policy rate still badly lagging inflation, while Japan would make tidal waves in markets with any departure from current policy. Sources at the BoJ claim a policy review is possible the end of Governor Kuroda’s term - depending on inflation and the outcome of the annual spring wage negotiations - which will lead to increasing apprehension as the time approaches.
This week’s weekly summary is longer than usual, but the valuations of all assets are measured by comparison with risk-free rates, and with markets pricing a more benign outcome for fixed income than expected by the Fed, the battlelines for next year have been drawn. The investment landscape remains hostile but those sectors that trade on reasonable valuations should survive another year relatively unscathed, assuming a deep recession is avoided. Energy however, is unlikely to have anything like the same performance next year, while growth sectors remain vulnerable to further earnings disappointment.
This week’s macro events
Monday 19th
Germany IFO Business Climate survey December
UK CBI Trends survey – total orders and selling prices December
US NAHB Housing Market index December
Tuesday 20th
Germany PPI November
US housing starts and permits November
Wednesday 21st
Japan BoJ meeting
UK public sector finances November, CBI retailing and wholesale reported sales December
Germany GfK consumer confidence January
US existing home sales November, weekly MBA mortgage applications, Conference Board consumer confidence December
Thursday 22nd
UK final estimate Q3 GDP
Italy industrial sales October
US final GDP estimate Q3, weekly initial and continuing claims, Kansas City Fed manufacturing index December
Friday 23rd
Japan national CPI November
France PPI November, Italy consumer, manufacturing and economic confidence surveys December
US personal income and spending and PCE deflator November, durable goods orders November, new home sales November
[1] November’s OECD Global Economic Outlook showed vacancies per unemployed person in 2022 were roughly double the level of the period from 2014-19 across most of the G20.