Mortgage Maelstrom

Global equities last week reversed most of their gains seen the previous week, falling 1.9% in local currency terms and 1.4% in sterling terms. The US held up best, benefiting from its defensive nature, while China fared worst, not helped by Biden’s unfortunate reference to Xi Jinping as a dictator which set back the recent attempt to improve US-China relations.

The UK came in middle of the pack, posting a drop of 2.7% despite the unexpected bad news on inflation and 0.5% hike in rates. More on this later.

The biggest shock came at the weekend from Russia with Prigozhin’s aborted coup attempt/march on Moscow. But the market reaction has been limited, with equities down a little this morning, for the obvious reason that the implications are far from clear to say the least.

Rather easier to analyse were the business optimism numbers released on Friday which showed confidence in the US, Eurozone and UK declining more than expected in June. Even so, other than in the Eurozone, where confidence is back down to borderline recession levels, sentiment overall remains in expansionary territory.  A still reasonably buoyant service sector continues to offset recessionary conditions in manufacturing.

All three regions will quite likely see a dip into mild recession at some point over the coming year as monetary tightening bites, posing some downside risk to equity markets. That said, recession is still not a foregone conclusion as was highlighted by the news that housing starts in the US surged 17% in May.

This at first makes no sense given US interest rates have risen sharply and housing is the archetypal rate-sensitive sector. In reality, the vast majority of US mortgagees are on 30-year fixed rate deals, so are not exposed to higher rates unless they move home. This explains why housing supply is very low at the moment and a surge in starts not as inexplicable as it seems.

This brings us onto the UK where fixed rate mortgages are generally only 2-5 years in term and mortgagees consequently considerably more exposed to rising rates, albeit with some lag. It is estimated that by year-end, close to 40% of mortgagees will have suffered the impact of higher rates (either because they have a tracker or their fixed rate deal will have expired) while by the end of next year, the proportion will be up to nearly 60%.

Inflation was a big disappointment in May, surprising on the upside for the fourth month running. The headline rate was unchanged at 8.7% but the more important core rate picked up from 6.8% to a new high of 7.1%. This fuelled worries that inflationary pressures are becoming entrenched, particularly with services inflation now running as high as 7.4%.

The Bank of England duly hiked rates by 0.5% to 5.0%, rather than by 0.25% as had generally been anticipated and was the case in March and May. The Bank left its forward guidance unchanged and kept its options open, sticking to the mantra that further tightening would be required if there were evidence of more persistent inflation pressures.

Almost certainly, the MPC will raise rates again in August. The only question is whether it is by 0.25% or 0.5% which will depend on the wage and inflation numbers released in the meantime. As to where rates peak, the market is now pricing in them reaching as high as 6%. Once again, this looks on the high side but this is said with some humility. The market has recently been rather more accurate on the path for UK rates than most economists, particularly those at the Bank of England.

The market reaction to these developments was limited. UK equities were down over the week but no more than most markets, although mid cap stocks, which are more exposed to the domestic economy, fell more than the FTSE 100. Short dated gilt yields rose 0.15% but long-dated yields were down 0.1%. As for the pound, it ended the week a little lower against both the dollar and the euro.

Rupert Thompson – Chief Economist