Most equity markets finished the week in negative territory as the news that China started to ease its Covid 19 restrictions gave way to continued fears over monetary policy tightening in the face of stubbornly high inflation. On Friday the latest US consumer price index is due for release, with forecasts of inflation remaining at 8.3% over the year to May, in line with April’s data. Markets are pricing in US interest rates to hit 2.8% by the year-end, versus the current rate of 1.0% (range 0.75% to 1.0%) and exceed 3.0% next year.
This is against slowing forecasts for economic growth, with the OECD (Organisation for Economic Cooperation and Development) lowering global forecasts down to 3% from their previous forecast of 4.5%, made in December due to the war in Ukraine and higher energy prices. Normally central banks are tightening monetary policy into strengthening growth, therefore the risk of stagflation (rising prices, slowing growth and rising unemployment) is that much greater in today’s environment.
As of 12pm London time on Friday, US equities fell 2.2% over the week, with the US technology sector falling by a similar level. European equities dropped 2.8% as even the European Central Bank (ECB) signalled that rates could be back above zero for the first time in a decade by their September meeting. This is against a backdrop of inflation running at 8.1% in the Eurozone, four times the target level of 2.0%. UK stocks fell 1.9%, as the country was ignominiously singled out by the OECD as most likely to suffer from stagflation next year.
The OECD forecasts the UK to have the weakest economy in the G20 outside of Russia in 2023. The Japanese market rose by 0.5%, helped by a sharp devaluation in its currency, the Yen, as the Bank of Japan is one of the few central banks not expected to raise rates anytime soon with inflation currently running at 2.5%. Although this is remarkable in itself in a country that has battled with deflation for many years. Australian stocks fell sharply, as the market lost 4.2% over the week.
Emerging markets rose 0.6%, although this was primarily down to Chinese stocks which rose following the relaxation of Covid restrictions, as the state media announced on Sunday that public transport and restaurants would reopen in Beijing. The domestic Chinese ‘A’ share market rose 2.8%, whilst offshore Hong Kong stocks gained 3.4%. The Latin American subsector of the emerging markets fell by 5.3%, not helped by the US dollar strength.
Government bond yields, which move inversely to price, rose over the week, with the 10-year US Treasury yield rising to 3.03%. Similarly, German bunds rose to 1.41%, and UK gilts climbed to 2.31%, levels not seen since 2014.
Gold fell 0.3%, now trading at $1,845 an ounce, whilst Brent crude rose to $124 a barrel, taking it perilously close to the peak experienced just after Russia invaded Ukraine when it hit $128 a barrel.
The market is preoccupied with inflation once more, with concerns that stubbornly high inflation will require central banks to tighten monetary policy to a level that triggers a recession. And whilst we cannot rule out a further higher spike in energy prices, triggered by the Russia-Ukraine war, as time moves on, given that inflation is a year-on-year comparison, it becomes increasingly likely that it will at least start to moderate.
Research published from the Leuthold Group this week suggests that, since 1940, although inflationary spikes tend to trigger a recession almost half of the time, once inflation has peaked, the stock market tends to rise regardless of whether a recession occurs.
So, while it is still too early to call a peak in the inflationary cycle or a bottom in the stock market, it is not all doom and gloom and there are good reasons to start to become constructive on markets.
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