Summer markets

Source: Tatton Investment Management, "Tatton Weekly" 11/08/2023

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Summer markets

On the face of it, the week contained many of the news headlines that market optimists had been waiting for: rapidly falling US inflation and a cooling jobs market. In the UK, news that four of its major high street lenders were lowering mortgage rates was then followed by confirmation that GDP growth was positive rather than stagnant in the second quarter.

Yet the erratic yo-yo trading pattern of volatile markets over the week would suggest to the outsider that bad news had dominated. So, how are market actors pricing the news flow at the moment, and what, if anything, has changed?

Active investors are a pretty diverse bunch; different people with differing views, approaches, time frames and interests. However, one shared trait appears to be that in aggregate they are quite astute. Active investors are good at taking the available information and judging how and where things are going.

Commentators often talk about what is ‘discounted in the market’ but, oddly enough, it is difficult to know what is factored in until we get the next piece of information. Only then, by looking at the subsequent changes in asset prices, can we tell whether this was really new information or just corroboration of what we knew before.

Indeed, this week was one where we had such an instance. On Thursday, the US Bureau of Labor Statistics released its consumer price index (CPI) inflation data for July, and it was relatively benign. In particular, the core CPI measure (with food and energy taken out) was +0.16% for the month, and the same as June’s datum. For the two months, annualised core CPI is now running below 2%, at +1.92%.

When the June data was released last month, it defied economist predictions (the average expectation was +0.3%) and the bond and equity markets reacted as one might expect. In the following 36 hours the 10-year yield went from 3.95% to 3.75%, and the S&P500 rose 3% over 48 hours. The market narrative was that this would enable the US Federal Reserve (Fed) to keep interest rates on hold for the near future, with the prospect that they could start cutting next year.

The July data again surprised (economists were expecting +0.22%) and commentators repeated  the June narrative: the Fed will be able to stop raising rates and then begin cutting next year. The bond market had seen a dip in yields as the data was about to be released but, immediately after, yields rose. The 10-year yield went from 3.95% as the CPI data was published, to 4.10% by the close. As I write, yields are up to 4.15%. Meanwhile, the S&P500 is pretty much unchanged.

So, for equities and bonds, what was a bullish driver has become less so now. Investors have had quite a lot of the ‘immaculate disinflation’ narrative in the past weeks and corroborative data is not new information.

Moreover, there is a danger that disinflation (a slowing in the inflation rate) is not so immaculate. The description attempted to convey the idea that, while the inflation component melted away, growth could and would remain strong. This is where the week’s news flow about falling inflation begins to turn counterproductive. China also released July inflation data this week and that was unambiguously deflationary (rather than disinflationary). On a year-on-year basis, consumer prices fell 0.3%. Yet again, producer prices were also down 4.4% year-on-year.

The problem is that it is weak growth which creates the falls in prices. One can argue that China’s problems are a benefit to western consumers and businesses. Businesses that compete with Chinese exporters are finding they are losing pricing power, while suppliers of commodities to China are experiencing a sharp slackening in demand. Thus, weak growth in China may be transferring to the rest of the world.

Oddly perhaps, in the energy markets, OPEC’s attempts to tighten supply has borne fruit with a rise in global oil prices in the past month. This has led to a (remarkably immediate) follow-through here in the UK, where petrol and diesel prices have risen by about 10p a litre. The same is occurring in Europe and the US.

Again, it’s not just oil; a strike by Australian natural-gas workers caused a 40% rise in European near-term delivery natural gas prices. Australia is the world’s largest supplier of liquid natural gas (LNG), most of which goes to Asia (especially Japan). However, our biggest suppliers (US and Qatar) can also supply those markets so it has had quite an impact as LNG markets are proving more global than they perhaps used to be.

And in food markets, the typhoon season has pushed up rice prices.

Of course, central banks and investors like to look at inflation with food and energy stripped out precisely because they are volatile components that usually have a less structural impact, as they  usually fall as quickly as they have risen. However, in the current situation, as global economic growth may be coming under threat, investors worry that a renewed – even if temporary – price push from the volatile end of the inflation spectrum may cause a delay in the path towards easier monetary policy.

Back at home, the Royal Institute of Chartered Surveyor’s report on the housing market continued to show a likelihood of further house price falls which, in earlier years, would be a harbinger of very difficult economic times. Yet the UK economy put in yet another quarter of growth, albeit anaemic, at +0.2%. The really surprising aspect was that July manufacturing and construction output (contained in a separate report) was very strong at +2.4% and +1.6% month-on-month, respectively. That echoed the construction purchasing managers’ index (PMI) from last week, which showed a totally surprising shift into growth territory at 51.7 (50 marks the divide between contraction and expansion). Perhaps unsurprisingly, bond yields shifted sharply higher on Friday after the data, with the 10-year testing 4.5% and the two-year back at 5%. Neither has yet broken beyond the highs of the past month, however.

While estate agents may be pessimistic, a lowering of general house prices may be offsetting the rise in interest costs. Perhaps housing may be approaching (just about) affordable territory for the huge cohort of young adults who have been trapped in the rental market. In that case, housing activity could have a structural support (!).

August is generally a quiet month, with many taking a holiday. For the newspapers of old, it was always known as the ‘silly season, when stories of little importance would be given headline status. In recent years, August has felt more like business-as-usual, but market liquidity can still be somewhat reduced and, if news is really important, can lead to sharp dislocations. So far this month, the stories are not unimportant, but neither are they earth shattering. Volatility has picked up a little, but is still way down from last year and even the first half of this year. So, it’s probably best not to make too much of the little worries that are crossing the path this week.

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