May ended on a positive note for equities as they regained their end-April level (MSCI ACWI), but June has seen renewed weakness. At close of trading on 8 June, they had lost ground month-to-date. Some economic indicators have remained strong, but investors – concerned about a possible recession, inflation that looks like staying higher for longer and the prospects of tighter monetary policies – remain hesitant.
So far, the US picture is bright…
The US labour market is still strong: there was better-than-expected news that 390 000 new jobs were created in May for a total of 2.4 million net new jobs this year. The unemployment rate has stabilised at 3.6%, with the labour force participation rate rising after slipping back unexpectedly in April.
Against this backdrop, wage growth continued to slow but remains high in absolute terms, up by 6.5% year-on-year for production and non-supervisory employees.
Business surveys point to slowing growth in the coming months, but this would follow a high pace of GDP growth at the end of 2021. Purchasing managers’ indices continue to indicate expansion.
Domestic demand has so far withstood the effects of rising inflation. Even though private consumption expenditure grew by 0.7% in April after 0.5% in March, high prices, particularly for petrol, have begun to undermine household confidence. The University of Michigan consumer confidence index fell in May to its lowest since mid-2011 and the price of a gallon of regular petrol now exceeds the symbolic five-dollar threshold in many states.
…but will there be a recession?
Economists are divided between those giving the US Federal Reserve (Fed) the benefit of the doubt over its ability to engineer a soft landing for the economy and those who are convinced it will drop the ball, with rising policy rates leading to a recession.
Whichever outcome pans out, the fact is that mentions of the ‘R’ word – recession – have increased sharply since February both on Wall Street and Main Street, reflecting a rising level of concern among investors and economic agents. That is becoming a worry for the Biden administration with mid-term elections coming up in November.
The Fed appears to be focusing on hitting its 2% inflation target and looks set to continue its rate-rising cycle until it has ‘clear and convincing’ evidence that price stability has been restored. Economists’ and market expectations have already adjusted broadly to this notion.
European Central Bank: No more baby steps?
After the latest ECB council meeting, it may take some time for expectations around eurozone monetary policy to stabilise. In May, the number of hawkish comments from council members multiplied, including from some who have generally been neutral or even dovish. This has caused monetary policy expectations to shift.
The ECB has now confirmed that ‘the Governing Council intends to raise key interest rates by 25bp at its July monetary policy meeting,’ but also indicated that it ‘expects to raise them again in September. The calibration of this rate increase will depend on the updated medium-term inflation outlook.’
The central bank did not deny that a larger rate rise, perhaps of 50bp, may be ‘appropriate in September’. It foresees beyond that a ‘gradual, but sustainable sequence of further increases.’
Like the Fed, the ECB seems to have overhauled its analysis and inflation forecasts. President Christine Lagarde clarified that ‘price rises are becoming more widespread across sectors (…), wage growth has started to pick up, and (…) initial signs of inflation expectations above target warrant monitoring’.
The ECB forecasts inflation at 6.8% in 2022, 3.5% in 2023 and 2.1% in 2024. The comparison with forecasts in March (respectively, 5.1%, 2.1% and 1.9%) underscores the notion of inflation remaining ‘higher for longer’, all the more so as core inflation is now expected to hit 2.8% in 2023 – well ahead of the 1.8% forecast in March and above the ECB’s 2% medium-term inflation target.
These figures are high and they underpin a significant change of the ECB’s scenario. Investors will need to digest this, just as they did the Fed’s change in tone a few months ago.
In the short term, the surge in bond yields that followed the ECB’s latest comments is adding to volatility and nervousness in both fixed income and equity markets. We believe this justifies the more cautious position we have adopted in our portfolios, in particular by reducing our exposure to eurozone equities.
Indeed, the ECB’s more-hawkish-than-expected monetary policy stance comes on top of a slowdown in growth, the geopolitical turmoil arising from the Ukraine conflict and, from a microeconomic point of view, earnings prospects that do not seem to fully take these headwinds into account yet.