UK Joins The Party

UK markets gave a collective cheer to last week’s news that UK inflation had for the first time for several months surprised on the downside. Equities rose 3.1% over the week and domestic stocks led the gains with the FTSE 250 up 3.9%. As for Gilts, they rallied 1.2% with 2 and 10-year yields both falling around 0.2% to 5.0% and 4.3% respectively.

Headline inflation dropped to 7.9% in June, below the consensus forecast of 8.2% and down from 8.7% in May. Energy prices were the biggest factor behind the fall, but even so the core rate also posted an unexpected decline, slowing to 6.9% from 7.1%.

One swallow – however welcome – doesn’t make a summer and inflation remains considerably higher in the UK than in the Eurozone or US. Services inflation remains a worrying 7.2% and wage growth is running at a similar level. Both will remain a major concern for the Bank of England. Even so, a rate rise of 0.25% to 5.25% on 3 August now looks more likely than the 0.5% hike which had been in the offing.

Markets have duly scaled back their expectations for the peak in UK rates to 5.75% from a high of 6.5% at the point of maximum inflation hysteria earlier this month. Rishi Sunak is also now back on track to meet his pledge to halve inflation by year-end. The headline rate looks likely to be down to 4-4.5%, even if the core rate is still running at 5.5-6%.

Meanwhile, consumer spending is holding up surprisingly well in the face of all the gloom and doom and surge in mortgage rates. Retail sales volumes posted an unexpectedly strong 0.7% gain in June and are down a comparatively modest 1.0% on a year earlier.

All said and done, the recent crop of numbers paint a picture of the UK which is rather better than the basket case assumed by UK equities with their very low valuation. We remain overweight the UK with a significant exposure to small and mid-cap stocks on the basis that markets can only be pleasantly surprised given their current pitiful expectations.

Unsurprisingly, the pound weakened on the back of the scaling back of interest rate expectations, retreating to $1.2850 from its recent high of $1.31. The silver lining here for UK investors was that this transformed last week’s gain in global equities of 0.6% in local currency terms into a 2.3% rise in sterling terms.

Outside the UK, there was no major news driving markets other than the US second quarter earnings season which is in full swing. With close to 20% of companies reported, there have been no big surprises but earnings overall are coming in a bit weaker than forecast. The expectation is now for S&P 500 earnings to be down 8% on a year earlier or 2% excluding the energy sector.

The tech behemoths report their results over the next week or two and will be a major focus given they have driven the bulk of the gains in the US market so far this year. Indeed, the tech sector was for a change the worst performing sector last week following disappointing numbers from Netflix, Tesla and also TSMC, the world’s second largest semiconductor company.

Still, the main centre of attention this coming week will be the meeting of the Federal Reserve on Wednesday, where rates should be raised 0.25% to 5.25-5.5% in what is expected to be the Fed’s last rate hike. Thursday should also see the European Central Bank increase rates by 0.25% with a further rise anticipated in September, while on Friday the Bank of Japan is likely to leave policy broadly unchanged.

Rupert Thompson – Chief Economist