Where Are We Headed?
This weekly is on the early side and I am wary of what Friday brings, especially as the debt ceiling saga gives rise to further bond market volatility.
Here’s a quick catch up on key news flow from last week:
(1) Euro-Area March core inflation rose again and surprised to the upside demonstrating continued strength in food and core goods; wage growth also surprised to the upside; (2) core inflation also surprised to the upside in the UK raising the odds of a 0.25% rate hike; (3) In the US inflation slowed – shelter slowed down too; (4) China Q1 GDP beat expectations rebounding to 2.2% q/q, 4.5% y/y, led mainly by consumption and services. Retail sales gained 10.6% y/y while industrial output still lags at 3.9% y/y. Fixed Asset Investment slowed to 4.8% y/y on softer manufacturing and property investment. House prices recover modestly at 4.6% y/y in the 70-city index; (5) Singapore, Indonesia, Australia – all kept rates on hold
This week sees further earnings announcements, especially around banks. Analyst calls show large banks have not yet materially tightened lending standards while regional have or are about to. Furthermore, regional banks are projecting a larger-than-usual rise in deposit betas (i.e. a ratio that compares the portion of change in the Fed Funds Rate vs what is passed on to the Deposit rate). The impact of this is to put stress on profitability (lower net interest margins as banks have to pay depositors more) – unless the loan book and/or investments can compensate. Investments typically comprise Treasury securities (not exclusively but mostly) and yields right now are volatile.
We had the US GDP and PCE Inflation releases. The GDP release was below consensus - but the devil is in the detail. Q1 2023 GDP rose at 1.1% y/y (vs 2.6% for Q4 2022). The forecast was for 2.0% was expected. However, the decline in inventories, of -$1.6bn which cut GDP by -2.26%, was the main driver. Without this, government & trade, GDP would have registered a very healthy 2.9%. Domestic final sales increased 3.2% while consumption reaccelerated to 3.7% (faster than rate than the +1.0% rate in Q4). This time, it was the business sector (+0.70%) that held back growth with fixed investment looking weaker than expected. Furthermore, the labour market remains tight - for w/e 22nd April, jobless claims fell -16,000 to 230,000 marking quite a drop on the previous week and beating forecasts. The PCE inflation release showed a bigger drop in the core rate over the headline rate. The Fed swears by this measure because it shows how much consumers are paying for goods and services vs its 2% inflation target. Consumers account for over two-thirds of the US economy. Today’s print shows high but slowing inflation. Latest betting odds on rates? 90% odds for a 0.25% hike at the next session with less than 20% for one more after that (also 0.25%) at the session after with rate cuts soon after! Business activity is in expansionary territory at both services (53.7) and manufacturing (50.4) levels with a big surge in the new orders sub-index.
Europe is showing robust economic activity as demonstrated by the flash composite (services and manufacturing) PMI data which rose to 54.4 (a big move into expansion territory). The UK came in at 53.9. Splitting these data releases shows service activity into the high 50s while manufacturing is still sluggish. Central Banks on both sides of the Atlantic are not finding it easy trying to tame inflation. German trade unions have strong bargaining power as demonstrated recently by the Ver.Di trade union with its 1.9mn members. It is the second largest union in the country after IG Metall. Ver.Di negotiated close to a 12% pay deal with the government over the next two years and could see such settlements spreading to other sectors. The UK’s public deficit undershot quite significantly and sets up a potential tax giveaway a year from now.
Asia, on the surface, sees mixed news but a key factor is that trade is picking up as China reopens. South Korean Q1 GDP grew 0.3% q/q to 0.8% y/y (boosted by private consumption which rebounded) while exports bounced 8% in the first twenty days of April. Chinese exports gained in March while Japan’s inflation rose again to 3.8% y/y and remains persistent across other countries in the region (e.g. Australia)
Conclusion: The above is hardly a picture of imminent recession! Granted there is still fragility around the likes of FRB (First Republic Bank, whose share price is down almost -97% YTD). Officials are trying to coordinate urgent talks to rescue it – a deal has yet to be reached with the private sector. Until then, it remains on FDIC’s balance sheet and we keep our fingers crossed there are no more FRBs that come to the fore. Then there’s debt ceiling debate which is hotting up – this week saw the Republican-led House of Representatives pass a bill that would cut spending by -$4.8TN with an increase in the debt ceiling limit to $31.4tn. There’s no way the Democratic-led Senate will buy it but it’s a tactic aimed at getting President Biden to engage in budget talks. The spending cuts amount to about -9% and thereafter spending growth will be capped at 1% pa for 10 years thus saving $3.2tn. The proposal would cancel unspent healthcare, infrastructure, rental aid funding, it would undo Biden’s efforts to cancel up to $10,000 in student debt, it would repeal Green Tax initiatives, tighten work requirements and provide more incentives for Oil and Gas which has currently stalled. The Republicans want to cut borrowing which results in lower borrowing costs (i.e. Treasury bond yields fall). The Democrats see it differently. And then there’s the options market which is spicing up. A single buyer last week bought $16mn in VIX options that would pay out if volatility spikes in June. The VIX futures are trading at just over 16% right now which means they are cheap. Meanwhile, markets are on a run – the NASDAQ is +16.51% YTD so there’s a case to keep loading up on the VIX (protection. Even if it drops and loses you money on these same futures, the upside gains from being directionally long the markets will more than make up for it. Meanwhile, nervousness is also displayed in the CDS (bond insurance) market: the 5y US CDS is over 60 bps wider (i.e. the value of this insurance has risen). Alongside all this, economies are picking up, the labour market is still tight and the consumer is hanging in there while wage rises are matching core inflation. Headline inflation is very slowly coming down to core inflation levels and so strangely we hit a three-way equilibrium – wage growth, headline inflation and core inflation are all on par. The rate of decline in inflation is worryingly slow.
Something has to give. Either growth tumbles or credit calms down. Bizarrely, we could be in a goldilocks scenario – steady growth and steadying inflation matched by steady rates. It doesn’t feel like it because we’re not used to this type of situation. Meanwhile, markets keep churning upwards – at least till end of June. After that, watch what inflation does again!