Peak Rates

Global equity markets resumed their recovery last week, gaining 0.6% and 1.3% in local currency and sterling terms respectively. The UK was one of the best performers, gaining a strong 2.9% while the US underperformed with a 0.6% rise.

The outlook for interest rates is very much the centre of attention at the moment, with the ECB meeting last week and the Fed and BOE both meeting over coming days. Unlike bonds, where US yields have edged back up to their August highs, equities are focusing on the positive rather than negative side of the prevailing central bank mantra that rates are set to stay higher for longer.

Rather than being pulled down by fast fading hopes of any early rate cuts, equities are taking heart from the quid pro quo that rates won’t have to spike higher in the meantime. Markets expect the BOE to raise rates a further 0.25% on Thursday but believe rates will then have peaked, not only here but also in the US and Eurozone.

The latest US inflation numbers suggested the optimism surrounding the recent decline has been somewhat overdone but did nothing to change the market’s firm belief that the Fed will leave rates unchanged on Wednesday. A rebound in petrol prices led to headline inflation moving back up to 3.7% from 3.2%. As for the more important core measure, the monthly gain was larger than of late yet the annual rate eased to 4.3% from 4.7%.

Meanwhile, the ECB on Thursday increased rates a further 0.25% to an all-time high of 4.0%, a decision which had been hanging in the balance. Its latest guidance is effectively that rates have very likely now peaked but it remains data dependent and a further rise cannot be ruled out. The exact wording will differ but this core message is also likely to be spelt out by the Fed and BOE later this week.

Last week’s crop of UK numbers had little impact on expectations for the forthcoming BOE meeting. GDP was unexpectedly weak in July, falling 0.5% and reversing its gain the previous month. The underlying picture remained one of stagnation, with economic activity unchanged on a year earlier.

UK wage growth picked up more than expected to a new high of 8.5% in July, boosted by one-off payments to NHS workers and civil servants. Underlying wage growth was unchanged at a somewhat lower 7.8%. Concerns over the continuing high level of wage gains will have been eased a little by signs that the labour market is cooling. Employment is now falling and the unemployment rate edging higher.

Wednesday is likely to see headline inflation in the UK move back up in August to 7.1% from 6.8%. As in the US, this will be mainly down to petrol prices. The rise has been widely flagged and should not ruffle too many feathers at the MPC.

Wednesday also sees the Chinese central bank meet and here it’s a question of whether they leave rates unchanged or nudge them down a little further in their ongoing attempt to boost growth. In contrast to the numbers of late, retail sales and industrial production growth surprised on the upside in August, suggesting investor sentiment has very likely become too negative on the Chinese outlook.

For equities more generally, the current willingness to look on the bright rather than dark side of rates remaining higher for longer does leave markets a little vulnerable. That said, economic stagnation looks more of a risk than a meaningful recession, limiting the potential downside. Furthermore, unlike in the US where elevated valuations reinforce the downside risk, valuations elsewhere are cheap and should be supportive.

Rupert Thompson – Chief Economist