Last Wednesday the US Federal Reserve (Fed) delivered its expected 75bps rate hike, taking the target rate well above 2%, and with more priced into markets for later in the year.
The next day US GDP was shown to have contracted by 0.9% in Q2, after a 1.6% fall in Q1. Is the US already in recession? Technically perhaps so, but in the US the preferred approach is to use the National Bureau of Economic Research (NBER) definition – and they look for a broad deterioration in activity and take account of what is happening to the labour market before calling a recession.
US real consumer spending actually grew again in Q2 with the biggest negative contribution coming from inventories. However, there was a fall in fixed investment, mainly residential housing, and government consumption also declined. Overall Q2 saw a broader and more domestically orientated decline in GDP than Q1. Recession? Not yet, but the odds are increasing. The key will be the labour market, which is holding up well. But this is a double-edged sword: the Fed needs to see weakness in employment data and will continue to hike until it feels that the inflationary pressures from tight labour markets have abated. As a lagging indicator, there is a risk that rates are hiked and a sharp recession results. Soft economic landings are more talked about than actually delivered.
Difficulties aren’t limited to the US
Where the US leads Europe follows – is a mantra that usually works well. Europe is facing its own problems courtesy of rising gas prices. There seems to be recurring maintenance issues with the pipelines carrying Russian gas to Germany. Quelle Surprise! Given the cold war tensions and the sanctions imposed on Russia – this is just tit-for-tat. The latest Economic Sentiment survey from the EU makes sobering reading. Consumer confidence hit an all-time low in July, pessimism surpassing that in the early months of Covid. Again, the labour market shows some resilience with unemployment expectations remaining below the long-term average. And euro area data showed GDP beating expectations. But given the headwinds coming from the US, a painful squeeze on disposable income and falling business confidence the outlook is challenging.
Where does this leave the UK? Well, according to the latest International Monetary Fund (IMF) World Economic projection, pretty close to the bottom of the league table. For 2023 the ‘advanced economies’ are expected to grow by 1.4%, with the UK at 0.5%, only beating Russia which is expected to contract by 3.5%. This bearishness on growth was reflected in the performance of UK government bonds; at the end of the week 10-year yields were below 1.9%. For the first time in a while real yields were lower, bucking the trend of the last six months. The UK was not alone in seeing moves lower in government yields. In the US 10-year yields finished below 2.7% whilst in Germany the equivalent yield ended around 0.8%, half the rate seen a month ago.
On the credit side there was a move lower in yields across the board. High yield spreads, on my preferred index measure, fell below 6%, a rally of 80bps in three weeks. Investment grade also rallied with the non-gilt sterling credit spread moving towards 1.5%. Both look good value to me even with the moves tighter.
Real world inflation
Over the weekend I went up to Cheshire to visit my brother and had a great barbeque (under shelter!) with family members. As a dairy farmer he has seen incredible inflation in his raw materials such as soya, fertiliser, and energy. He is also struggling to get workers who will milk at weekends. And a remark by my brother struck me. From his perspective the Bank of England has had its head stuck in the sand and had not appreciated what is going on in the real world (perhaps we should move the Bank to Stoke on Trent rather than the House of Lords, as recently mooted by Michael Gove, the ex- Cabinet minister). When asked about milk prices his view was that the recent rise was about capacity, not just supermarkets recognising the cost inflation experienced by producers. More farmers retiring, selling up and their children leaving the industry suggests to him a wider trend of higher food prices. This looks likely to me – cheap food will become a bit less cheap (more security tags on Lurpak?). I also think he is right about the Bank.
Congratulations to the England football team, the first major international trophy in 50 years. It is incredible to believe that women’s football was banned by the FA up to 1971. Looking back at my school life I loved sport and feel that it is an unappreciated aspect of education. So many life skills are better taught through sport and recreation – rather more probably than some supposedly academic subjects. As a lateral thought – if we treated sport more as a subject, where we were taught that in later life it would contribute to our physical and mental health – we could reduce the health costs of inactivity.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.