Testy Times

Equity markets continued last week their recent pattern of bouncing around a few percentage points above their mid-June low. Global equities ended the week down 1.2% in local currency terms and 0.2% in sterling terms but have opened higher this morning.

The June US inflation numbers were last week’s main focus and they didn’t disappoint, posting a nasty surprise for the second month running. Headline inflation jumped to a new 40-year high of 9.1% from 8.6% on the back of a sharp rise in energy prices. The more important core inflation measure edged down only slightly to 5.9% and there are increasing signs of inflation becoming more entrenched in the stickier components which will be hard to reverse.

However, there is rather better news on the horizon, at least for headline inflation. Commodity prices have fallen as much as 20% from their recent highs, with energy, metal and agricultural prices all down considerably. The Brent oil price last week dipped to $100/bbl, down from a high of over $120, although worries of recession were the cause rather than President Biden securing any increase in Saudi production.

The inflation news, along with an unexpectedly aggressive 1% rate hike by the Bank of Canada, fuelled speculation that the Fed could also raise rates by a full 1% later this month. However, Fed officials played down this possibility and most likely the Fed will hike rates by 0.75%, just as they did in June.

The bond market’s reaction to all of this was rather muted. 10-year US Treasury yields actually ended the week lower at 2.97%, well below their recent high of 3.5%. But the yield curve did invert further, pointing to a recession down the road, and the markets are now assuming the Fed will be cutting rates by this time next year.

Still, fears of an imminent recession were eased by a healthy gain in US retail sales in June despite the cost-of-living squeeze and collapse in consumer confidence. The UK economy also performed better than expected in May with GDP rising 0.5%. Although the gain was in part just down to a rise in doctor appointments, these numbers make it all the more likely the Bank of England will raise rates by 0.5% in August, rather than by 0.25% as has been the case so far.

Chinese GDP, by contrast, disappointed in the second quarter. It dropped a hefty 2.6% to be up only 0.4% on a year earlier. Activity should recover in the current quarter, now the major lockdowns have been relaxed, and retail sales growth bounced back into positive territory in June.

Even so, new Covid outbreaks are already appearing and the zero tolerance policy is likely to remain a drag on activity over the remainder of the year. Even with the support from increased policy stimulus, growth looks set to be not much more than 4% this year, well short of the government’s target of 5.5%.

The second quarter US earnings season kicked off with the big banks last week and it was a mixed story. JPMorgan Chase and Morgan Stanley disappointed while Citigroup and Wells Fargo beat expectations.  Overall, profits of the financial sector are expected to be down some 20% on a year earlier, largely as a result of investment banking revenues falling back from record levels.

Markets are likely to remain volatile for some months yet. We believe we will need to be much closer to the end of the current policy tightening cycle for equities to see a sustained recovery and for the upward pressure on bonds to come to an end.

Rupert Thompson – Investment Strategist