A Tug of War

Equity markets rose 1.8% last week, reversing the bulk of the previous week’s decline. China led the way with a 3.3% gain. Meanwhile, bonds had a mixed week with yields slipping back slightly in the US but rising in the UK and Eurozone.

The key drivers behind recent market moves remained in place, namely further confirmation that economic activity is holding up considerably better than expected but at the cost of continued inflation pressures.

Global business confidence, which had been flagging a fall into recession, improved significantly in February and moved back into expansionary territory for the first time since last August. The improvement was led by the service sector but manufacturing also improved a little.

Somewhat surprisingly, the UK saw one of the largest increases, with optimism now higher here than in the US or Eurozone. This is somewhat at odds with the general view that the UK will fare rather worse this year than the other major economies.

Further grounds for cautious optimism were provided by Rishi Sunak’s Northern Ireland trade deal. Assuming it doesn’t yet blow up in his face, it should provide a modest medium-term boost to the economy, both via the direct effect on Irish trade and by facilitating a more harmonious relationship with the EU.

Reinforcing the improved tone were comments from Andrew Bailey, the BOE Governor, suggesting that rates might not actually need to be raised further. But given the Bank’s previous record of leading the market up the garden path and rather more hawkish comments from the Bank’s Chief Economist, the market reaction was limited. It is still assuming rates will need to be raised from the current 4% to 4.5-4.75%, which looks on the pessimistic side.

Rather less surprising than the rise in UK confidence was the jump in Chinese optimism which appears to confirm that economy is now reopening fast. The authorities over the weekend announced a target of 5% growth for this year which should be met comfortably, unlike last year when growth undershot significantly.

In the Eurozone, the latest inflation numbers were the main focus and didn’t make pleasant reading for the ECB with inflation once again surprising on the upside. Headline inflation edged down to 8.5% but more importantly core inflation continued to rise, hitting a new high of 5.6%.

The rhetoric from the ECB is now the most hawkish of all the major central banks. Rates look set to be raised at least another 1% over coming months although this would still leave them peaking at only 3.5-4% compared to a probable peak of 5.25-5.5% in the US.

This Friday sees the release of the February US employment data. Always a major market focus, it will be even more so this time. January’s blow-out report marked the start of the recent spate of stronger than expected data and it will be crucial to see whether this strength was maintained last month. Some of the buoyancy in January may well have just been down to unusually warm weather.

Markets currently face a two-way pull. On the one hand, the unexpected resilience of the global economy has eased the danger of an imminent recession and reduced the downside risk posed by a fall in corporate earnings. On the other hand, it increases the difficulty of getting inflation under control and the need for further policy tightening, which itself raises the risk of a recession further down the road.

This all suggests markets are very likely to remain volatile over coming months.

Rupert Thompson – Chief Economist