Equity markets last week broke out of their recent torpor, posting a gain of 1.4% in both sterling and local currency terms. US equities outperformed, with a 2% gain in sterling terms, while China drew up the rear with a 0.6% decline. Japan was the star performer in local currency terms rising 3.2%, but a decline in the yen cut the gain in sterling terms to only 1%.
As for government bonds, they lost around 1.5% as yields rose some 0.2%. 10-year UK gilt yields touched 4.0%, their highest level since last October, while 10-year US Treasury yields tested 3.7%, a two-month high.
An easing in worries about a possible US debt default contributed to these moves. Without an agreement to raise the federal debt ceiling, the US may run out of money as soon as 1 June although the so-called ‘x-date’ could end up being a week or so later. Even then, default could be delayed a bit further as the government could for a while prioritise debt service payments over other spending.
Negotiations between President Biden and House Speaker McCarthy over the past week have been a stop-start and fairly acrimonious affair but are scheduled to re-start again today. Biden appears to be willing to accept the Republican condition of spending cuts being part of any deal, although with the so far unacceptable quid pro quo of tax rises. Very likely, some deal will be reached although not until the eleventh hour.
Default therefore remains very much just a tail risk. But if there were a temporary default, equities would undoubtedly be hit. As for the dollar and US Treasuries, the impact is harder to judge but somewhat paradoxically, the ensuing flight to safe havens might well lead to a strengthening in the US currency and a fall in US yields.
On the data front, it was a mixed affair last week. In the US, retail sales and manufacturing production both bounced back more strongly than expected in April from declines in March, suggesting the economy continues to hold up reasonably well. This, along with comments from various Fed officials playing down the likelihood of rate cuts later this year, contributed to the rise in Treasury yields.
Japanese growth also surprised on the upside. GDP rose 0.4% last quarter, the first gain since last summer. Increased optimism on the economy, particularly now that inflation seems finally to be trumping deflation, together with hopes that Japan is finally becoming more shareholder friendly, have been behind the equity market’s strong performance this year.
While Japanese equities are looking more attractive now than for some time, part of this year’s strong gains have just reflected a weakening of the yen. Only if the holdings have been currency hedged, has one benefited fully. The yen remains a wild card for Japanese stocks, particularly with the current uncertainty over how quickly the BOJ will abandon its super-easy monetary policy.
The burst of enthusiasm for China surrounding the reopening of that economy has waned recently, partly on the back of last week’s clutch of somewhat disappointing numbers. Although retail sales in April were up as much as 18% on a year earlier, industrial production and investment were up a more pedestrian 5% or so.
Chinese equities have now unwound a good part of their large gains around the turn of the year but China and Asia more generally remain two of our favourite equity regions. Although the economic rebound may not be quite as strong as hoped, growth still looks set to be considerably higher than anywhere else over the coming year. Valuations also remain cheap and supportive, unlike in the US.
Finally, we had the latest set of UK labour market figures. While these showed a softening in employment and a tick up in the unemployment rate to 3.9%, earnings growth remained worryingly high at 7.0% in the private sector and 5.6% in the public sector. Indeed, the market now believes there is an 80% chance of a final 0.25% hike in rates in June to 4.75%.
This coming week, the market’s attention looks set to be firmly focused on the game of chicken being played out in Washington.
Rupert Thompson – Chief Economist