Between the Lines – July 2023

All investors use insights, trends, and data from across the globe to help them make decisions. Quilter’s regular ‘Between the lines’ communication is an easy way for you to understand how a current topic might be impacting markets and influencing your investments.

Central bank inflation strategies begin to diverge

While headline inflation is falling in the US, Europe, and the UK, core inflation is not coming down as quickly, data in the first half of June showed. The numbers were particularly stark in the UK, where core inflation (excluding food, energy, alcohol, and tobacco) rose by 7.1% in the 12 months to May 2023, up from 6.8% in the year to April. This is the highest rate since March 1992.

What does this mean for investors?

The Bank of England (BoE) clearly has more work to do to tame the high inflation that prompted its latest 0.5% interest rate increase. As at 26 June, markets are predicting a terminal rate – the peak interest rate in this economic cycle – of 6.25%, while some economists think the question is not whether there will be a recession, but whether there needs to be one to halt the march of rampant price increases.

Evidence the global economy is becoming less synchronised is also beginning to emerge, as the European Central Bank (ECB) lifted rates by 0.25%, albeit noting that “inflation… is projected to remain too high for too long”. Markets now expect two further 0.25% hikes from the ECB, taking rates to a peak of 4% in October.

Meanwhile, the US Federal Reserve (Fed) hit pause at its June meeting, keeping rates at 5%, but also kept its options open, signalling further rises remain on the table in the months ahead. Conversely, a disappointing post-Covid recovery has seen China’s central bank reduce its medium policy rate by 0.1%, the first cut in 10 months.

Overall, this has prompted two-year bond yields – the annual interest delivered as a percentage of a bond’s price – in the UK, Europe, and the US to move higher through June, which offers more compelling prospects for new investments. However, as bond prices move in the opposite direction to yields, price returns have fallen in recent weeks.

Key takeaways

  • Inflation is likely to be higher for longer.
  • Interest rate rises are prompting new investment opportunities in developed market government bonds.
  • Central bank policy is diverging among developed markets.

Data casts shadows on developed market outlook

The future pace of developed market economic growth looks set to slow, leading indicators revealed in June. However, recent positive data in the US has questioned the likelihood of recession in the world’s biggest economy.

What does this mean for investors?

The picture is mixed in the US. Key metrics such as the Leading Economic Index, which weighs a range of factors such as the number of building permits issued for private housing and new manufacturing orders, have fallen in each of the past 14 months, signalling declining levels of economic growth.

Likewise, the Purchasing Managers Indices (PMI) in the US, Europe, and the UK, are pointing to an increased reliance on the service economy to make up for renewed weakness in manufacturing across the three regions. With these sectors having seen divergent trends for some months, they are unlikely to move in different directions for much longer.

However, aspects of positive news have appeared. In the US, Housing Starts, a measure of the number of new single-family homes under construction, jumped in May by the largest amount since 2016, suggesting that the US building sector may see renewed growth after a difficult 2022.

Consumer confidence is also recovering, as revealed by The Conference Board research group. Their monthly consumer confidence indicator hit a 17-month high of 109.7 in June, beating expectations of 104.0. The US labour market is also showing resilience and unemployment has stayed under 4% so far in 2023. This suggests a US recession is by no means certain, with the US Treasury Secretary, Janet Yellen, saying on 22 June “my odds of it, if anything, have gone down” citing strong labour markets and reducing headline inflation.

Continued vigilance is warranted, and investors will be watching growth and unemployment data closely. While many global and regional indicators still suggest an economic slowdown, they are not perfect guides. Over the last year, against many dreary outlooks and predictions, company earnings have generally been better than anticipated, with some developed markets delivering double-digit returns.

Key Takeaways

  • Recession risks remain, but a mixed data outlook calls the timing into question.
  • Unemployment remains low and investor sentiment is showing signs of recovery.
  • The current situation suggests a cautious stance remains warranted.

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