World economic & market update by Graham O'Neill June 2023

30 Jun 2023

World economic & market update by Graham O'Neill June 2023

In Spring 2022 we talked about regime change ruling the world and since then, the battle to control inflation has dominated investment markets. We saw the US Federal Reserve May 2022 meeting as pivotal, describing it as Jay Powell’s ‘Draghi Do Whatever It Takes Moment’ and since, the US Fed Chair has consistently reiterated to markets the total commitment of the Fed to return inflation to a 2% rate. The Fed believe the 2% rate is necessary to achieve enduring economic cycles with full or maximum levels of employment and, as long as inflation remains above the target, it would be very difficult for the US central bank to alter its inflation target without losing credibility. At the press conference following the June 2023 Fed meeting, Chair Powell stated that the Committee would ‘Do whatever it takes to get it (inflation) down to 2% over time’.


A rapid turnaround

Markets have been reluctant to believe in this mantra with commentary potentially influenced by many financial commentators’ self-interest in promoting a belief in a rapid turnaround on interest rate policy, but during the second quarter, all major central banks reiterated their commitment to reducing current levels of inflation. In the US, the core Personal Consumption Expenditure Index (PCE), the Fed’s preferred measure, is running above 4.5% at the core level, far above the targeted level of inflation and as Chair Powell has pointed out in recent months, headline inflation has continued to decline while some elements of core inflation have risen. Powell has explained that the only reason the Fed is projecting interest rate cuts a couple of years out is that by then, the Fed expect inflation at the core level to be on a significant downward trend, making rate cuts compatible with maintaining roughly the current level of real (post inflation) interest rates. The latest SEP (Summary Economic Projections) released at the last Federal Reserve meeting, which showed median expectations of a further two rate hikes along with upgrades to GDP growth and employment forecasts, ties in with an economy which, while only having slowly moderating inflation, has not seen the significant economic downturn forecast by many.


Inflation moderation in the US

Predictions of recession in the US economy for 2023 were a highly consensus forecast and to date, once again, the consensus appears wrong. Fears of a significant tightening in credit conditions post the regional bank problems in March appear to have dissipated, although the Fed has explained that they will continue to monitor this situation closely and, if there is a significant effect on available liquidity, there will be appropriate adjustments to interest rate policy. The Fed justified its recent interest rate pause by explaining it had raised rates by 500bp and, with the usual lagged effects of monetary tightening, it wants to proceed at a slower pace of rate tightening to maximise the likelihood of achieving a soft landing for the US economy where inflation moderates without causing a significant rise in the unemployment rate. Powell once again discussed the level of tightness in the US jobs market which appears to be resulting in significant wage rises. The Fed believe that this is incompatible with a 2% inflation rate and would clearly like to see a softening in labour market conditions before being able to cut interest rates. 


Industrial unrest in the UK

Europe has also seen core inflation lag declines in headline rates, with the fall in energy prices reducing headline Euro Zone inflation. ECB president Christine Lagarde believes the Euro Zone ‘Will face several years of rising nominal wages, with unit labour cost pressures exacerbated by subdued productivity growth’.  As a result, Lagarde has called for persistent high interest rates by the ECB.  Despite rates increasing from -0.5% in 2022 to 3.5% today, further rate rises are expected, and future rate cuts appear some distance away. 

The Bank of England surprised markets with a recent 50bp increase in rates and expectations of more to come and further increases, possibly to the 6% level. The UK economy has always been susceptible to an embedded level of high inflationary expectations as the history of the 70s and 80s demonstrate. Annual core inflation in May increased to 7.1% when services inflation was at 7.4%. The three-month moving average annual growth of private sector pay excluding bonuses was as high as 7.5% in April.  With low unemployment and shortages in many industries due to Brexit, a tight labour market is exacerbating growth in wages and, in these circumstances, workers won’t accept large reductions in real earnings. Attempts by the government in the public sector wage arena to hold wage increases way below inflation levels has resulted in significant industrial unrest. 


Trends and recession

Respected commentators such as Martin Wolf in the Financial Times believe that the only way inflation can return to a 2% level is through a sharp slowdown in the economy and higher unemployment, or in other words, a recession. With over 50% of UK mortgage holders facing re-financing in the next 12-18 months, the consumer is bound to be hit in time.

Looking at the individual developed market regions outside of Asia, the US seems best placed to avoid a stagflationary scenario with the dynamism of its corporates and energy independence. The Biden administration seemed to be quietly pursuing policies that will ‘Make America Great Again’ with the measures in the Inflation Reduction Act encouraging inward investment and reshoring by US multi nationals. Europe has benefitted from a mild winter, but this can’t be extrapolated into the future, so the region remains more susceptible to an energy shock than the US. Europe’s manufacturing sector also has a greater reliance on the Chinese economy where the economic rebound has not only been weaker than many commentators expected, but there seems to be a persistent post pandemic trend away from spending on goods towards services impacting on the economy in Germany where higher rates are also hitting its property sector hard including residential housing. 


Mixed messages

Bear markets have an easy definition - a fall of 20% - usually accompanied by general gloom and doom.  Calling the end of the bear market is more difficult but if you class it as the opposite of the declines, the S&P this quarter has shown gains of more than 20% from last October’s market low. It’s extremely hard to call whether this is just a bear market rally or the start of a new sustained upturn but, according to market wisdom, a hated rally is likely to continue. Many investors have been surprised by market strength at a time when earnings are falling, short-term rates are rising and the 3-month/10-year yield curve is showing extreme levels of inversion, which have typically indicated a recession is on the horizon. Furthermore, the gains have been slim, with the S&P driven by seven large cap tech stocks: Apple, Microsoft, Alphabet, Amazon, Nvidea, Tesla and Meta. Some of these have an AI theme or play within them. The last few weeks have seen some broadening out of the rally and with much of the market dominated by passive investment, stocks that dominate the index to an unprecedented degree will always benefit from general equity flows. 


Big in Japan

The other standout market in 2023 has been Japan which is now attracting overseas interest from underweight positioning. The bull case is that Japan is about to see a further improvement in corporate governance with companies facing all round pressure to return cash to shareholders (also from the Tokyo Stock Exchange) with a focus on companies with a price/book ratio below 1, which is around half the market. Buybacks hit a record last year and will accelerate further in 2023. There is also a belief that Japan’s economic cycle is out of kilter with other countries, partly due to its slow Covid-19 reopening with tourism, for example, bouncing strongly since last October. Recent Japanese PMIs have surged to 55, a level Absolute Strategy Research believe is consistent with 5% annualised growth. With investors underweight and looking to close out this position, Japan has benefited from strong inflows into large cap value names, although the cheapest companies, often small caps, have lagged as these have not attracted flows. Domestic investors have also been encouraged by signs that deflation has ended with core inflation now north of 3% and positive nominal wage growth. A weaker Yen may also be encouraging domestic investors to place more money into equities. Japan does seem to be seeing much stronger domestic demand after false storms on that front and the market is now a favourite of legendary investor Warren Buffet.


Demand in China

In contrast, investors have remained concerned about the economy in China where the post Covid-19 bounce has remained sluggish. The authorities in China are now looking at further stimulus measures including cutting interest rates. Economic activity in China does continue to improve but the momentum or delta of change has fallen from the initial post pandemic recovery. Looking at industrial production, retail sales and exports with the world favouring services over goods, manufacturing remains depressed.  High youth unemployment has sapped consumer confidence and consumers are concerned that the government promises on pensions and social security in the future may not be met, encouraging higher levels of savings. The Chinese have stepped back from big ticket purchases when it comes to cars and international travel. Within China, weak demand has created excess supply, so Chinese industry is facing deflation. Excess property supply is concentrated in lower tier (smaller cities) where there is not abundant organic demand. In this environment, the government is likely to try to manage through a multi-year slowdown rather than resorting to a big bang stimulus package that creates more problems in the future.


Unemployment in China

While the pace of recovery in China appears slow compared to the post pandemic recovery in developed economies, we must remember that China did not see the same level of fiscal support either to businesses or consumers that occurred in the West. Culturally the Chinese are often cautious after a downturn and smaller ticket items such as activity in restaurants and bars have improved dramatically.  In housing, new home starts are up 13% year on year, albeit from very depressed levels. The domestic service sector has seen a rebound and there has been a significant improvement in internal flights taken compared to international flights which remain only just above 10% of pre-pandemic levels. Youth unemployment is generally high and for the 16-24 age group is around 20%. The number of graduates has grown dramatically in China and expectations when it comes to jobs are high. Many sectors they would have hoped to go into such as technology and finance are seeing significant downturns. The level of youth unemployment is embarrassing for the Party but is unlikely to spill over into protests as young people do not want to jeopardise their future in a country where facial recognition technology on the streets is very advanced. To put the problem into context, around six million young unemployed people are around 1% of the workforce, and the overall unemployment rate in China remains relatively low at 5%. The government in China is focused on the economy in areas such as exports and GDP growth, and with the government focused on reviving the economy, there is no real mention of geopolitical tensions with the US in domestic news.


India & its favourable macro environment

In contrast to China, India now has a much more favourable macro environment and is attracting increasing levels of FDI as it seeks to establish itself as a manufacturing alternative to China and benefit from multinationals moving to China Plus One when looking at their supply chains. Infrastructure investment has always been a problem in India, but this now seems to have turned around with the construction of new roads and private investment in areas such as airports, gas and power distribution, renewable energy, and even parts of the railways. Furthermore, the government has embarked upon often difficult but essential reforms in agriculture and labour markets. India has long been lacking an investment cycle, but funding availability has improved, and today, not just state-owned banks, but private sector banks, insurance companies, infrastructure, investment trusts, and the corporate bond market can participate in financing infrastructure projects. The government of India has encouraged investment in local manufacturing through attractive tax and labour reforms and there are strong productivity improvements which a low labour cost economy such as India should be able to capitalise on. There is both a large domestic market and increasing levels of exports which stack up on the quality front against multinationals from certain businesses. Apple’s suppliers have invested close to a billion dollars to set up manufacturing units in recent years. 

A further attraction for investors is that India remains a democracy with a population that has a desire for reform and economic progress. Based on the British model, rule of law compared to other emerging markets remains strong. India is still a very attractive long-term home for investor money with its large domestic market and some companies now growing strong enough in terms of product quality to compete internationally. Demographics in the country remain positive and there is an underutilised but skilled workforce wishing to move away from subsistence agriculture. 



Markets have progressed over the second quarter as concerns over immediate recession dissipated and the recent Fed meeting showed an upgrade to projections of economic growth and employment and, although on the negative side, forecasts for the Fed funds rate increased too. So far, earnings have proved broadly resilient and investors expect improvements in profitability in 2024, although how this pans out remains to be seen. Valuations in the US do remain high by historic levels, although the headline number is affected by the ratings of the technology focused mega caps which have driven this year’s market gains. Outside of the US, equity markets appear reasonably valued outside of a lasting economic downturn, although concerns over persistently higher interest rates in today’s new investment regime will cap valuation levels, meaning a rapid return to previous market highs is unlikely to occur.  For long-term investors, there remain pockets of value which strong stock picking has the potential to exploit and when US rates eventually peak, the valuations within Asia and selective emerging markets, coupled with their stronger relative growth prospects, could reward investors with a medium-term horizon. 

Graham O’Neill, Senior Investment Consultant, RSMR


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