Eerily Calm

Global equities were flat last week. Europe and the UK fared best with gains of around 0.5%, while emerging markets were dragged down by a 2% decline in China. Despite the release of GDP data confirming a strong rebound in the first quarter as the economy reopened, Chinese equities suffered from worries that the US might further increase restrictions on its tech sector.

Stepping back a bit, the broader picture is that global equities in local currency terms are now back up close to the top of their trading range since last summer. In sterling terms, the rebound is rather less marked due to the recovery in the pound with equities just back to the middle of the range.

As striking as the recent grind higher by markets is their tranquillity. A key measure of US equity volatility has recently declined to its lowest level since the start of 2022. The calm is all the more surprising given the continuing uncertainties surrounding the key issues facing investors.

The biggest uncertainty still relates to whether the West, particularly the US, is headed into recession. Currently, there is a big disconnect between the coincident and lagging indicators of activity, which still show an economy holding up remarkably well, and a host of leading indicators which are all flashing red and pointing to a recession down the road.

This dichotomy widened further last week with business optimism unexpectedly strong in April, not only in the US but also in Europe and the UK. The latest gains build on the improvement seen in the first quarter and leave confidence in all three regions well above the levels typically associated with recession which were seen late last year.

We are sticking with our view that most likely we are headed into a recession as a good part of the tightening in financial conditions has still to bite. But we think the downturn should be mild as the economy is basically in relatively good shape as indicated by its recent resilience.

A similar level of uncertainty hangs over the prospects for corporate earnings. The first quarter reporting season is now well underway in the US and earnings so far are beating expectations, albeit by less than normal. The decline expected to be posted versus a year earlier has moderated a little to 5% since the start of reporting.

The consensus is forecasting an increase in earnings of 10% or so over the coming year. But if a recession were to unfold, further declines look certain to be seen and this remains one of the clear downside risks still hanging over equities.

The chance of a recession depends in part on how quickly inflation pressures ease and whether we are close to the peak in interest rates. Headline inflation has now fallen back substantially in the US to 5.0% from a high of 9.1% and in the Eurozone to 6.9% from 10.6%.

Unfortunately, the same cannot be said for the UK where inflation last week came in unexpectedly high for the second month running. The headline rate was 10.1% in March, down only a little from a high of 11.1%. Food prices were a major culprit, posting a gain of close to 20%, the largest rise for 30 years.

Luckily for Rishi Sunak, the latest numbers do not jeopardise his pledge to halve inflation by the end of the year. However, the Bank of England will be rather more concerned, particularly as core inflation failed to decline as anticipated and was unchanged at 6.2%. Worries will only have been reinforced by the news that underlying wage growth remained unexpectedly high at 6.6% in February, despite signs of a softening in the labour market.

All this has led to a jump in interest rate expectations. Having previously bought into the BOE’s recent narrative that rates were at or close to a peak, the market now expects rates to be raised as high as 4.75-5.0% from 4.25% at the moment. While one or possibly two further hikes do now look likely, the market’s response does seem a bit of an overreaction.

All said and done, the global macro backdrop remains considerably more uncertain than normal and the tranquillity in equity markets should be enjoyed while it lasts.

Rupert Thompson – Chief Economist