Flirting with Recession

Last week was a relatively quiet one on the data front and saw markets slip back a bit. Global equities were down 1% or so but remain up around 6% year-to-date. Bonds also lost some 2%, as government bond yields unwound some of their marked decline since October.

10-year government bond yields in the US increased 0.23% to 3.75% and 0.35% in the UK to 3.40%. The rise in the US was largely a response to the numbers the week before which showed the economy holding up considerably better than expected.

This resilience led the market to push up its US interest rate forecasts for the remainder of the year. It is now pricing in two more 0.25% rate hikes by the Fed in the spring and only one rate cut later in the year. Whereas a month ago, the market saw rates falling back to 4.4% by year-end, below their current level of 4.5-4.75%, it now expects them still to be at 5.0% which looks much more plausible.

While developments in the US have been the main factor behind this move up in yields, other factors have also at the margin contributed. Australia and Sweden both hiked rates unexpectedly last week and the Bank of Mexico also raised rates by more than anticipated.

It was also announced that Kazuo Ueda, a relative unknown, would be the new governor of the Bank of Japan when Haruhiko Kuroda steps down in April. While the immediate market reaction was limited, Ueda’s appointment comes at a critical time.

The BOJ has started to step away from its policy of quantitative easing and yield curve control, raising in December the cap on 10-year government bond yields to 0.5%. With inflation finally showing signs of re-emerging after decades of deflation, the BOJ is under pressure to abandon its super-easy monetary policy. The latter has been a factor depressing bond yields worldwide and the speed of this policy shift will be watched closely by global, not just Japanese, investors.

Meanwhile, oil prices have received a boost from Russia’s decision to cut production by 500,000 barrels a day, which amounts to around 0.5% of global supply. The Brent oil price ended the week up 6% at $84.6/bbl.

Here in the UK, the economy in the fourth quarter narrowly escaped falling into a technical recession, which requires GDP to contract for two consecutive quarters. Instead, GDP was flat, having contracted 0.3% in the third quarter. However, the economy ended the year on a weak note with activity falling 0.5% in December, hit in part by the wave of strikes.

The numbers also highlighted the poor performance of late of the UK economy (but importantly not the UK equity market) relative to its peers. GDP remains 0.8% below pre-covid levels in contrast to the US and Eurozone where it is 5.1% and 2.4% higher respectively. The UK is the only G7 economy where activity remains below pre-pandemic levels and with a shallow recession still on the cards for this coming year, this gap unfortunately looks unlikely to close any time soon.

This coming week, the US inflation numbers on Tuesday will be the main focus for the markets, with the headline rate forecast to fall back a little further to 6.2% and the core rate to decline to 5.5%. Just as these numbers will be watched closely by the Fed, this week’s data on UK wage growth and inflation will be a key factor in whether the BOE decides to raise rates again in March.

Rupert Thompson – Chief Economist