Another increase all round; but the Federal Reserve to cut by year-end, while the European Central Bank continues to hike.
Recession risks are now much higher in the US than they are in Europe, a reversal of expectations from the end of 2022. In the event of a recession, we can expect big interest rate cuts from the US Federal Reserve.
However, labour markets are very tight leading to high wage growth and core inflation across the US, Europe, and the UK, so interest rates will continue to rise until we see an easing of the labour market. That is likely to require clear signs of falling employment and recession in the US. Until that happens, the Fed is set to keep raising interest rates, though at a slower pace and with smaller increases.
This is all dependent on the data from the economy, with central banks clearly nervous after the collapse of SVB and rescue of Credit Suisse about how rapid interest rate hikes have created stresses and uncertainties in the financial system.
The credit crisis in the US is an issue. It predates the collapse of SVB, reflecting the surge in interest rates and clear expectations of a recession this year. However, there are now a swathe of smaller US banks who will no longer be looking for opportunities to lend money but instead focused on survival and shoring up their balance sheets.
There are risks of a credit crunch, though currently it is more of a credit squeeze as the affected banks represent a small proportion of overall lending.
Just as importantly, there are clear signs that the surge of consumers spending of their ‘Covid piggy-banks’ has weakened – real spending has flatlined over the last six months in line with real incomes. This was the key to keeping the US from a recession in 2022, it doesn’t seem likely to do the same again in 2023.
Europe has had a good start to 2023. Manufacturing is relatively weak as businesses clear excess inventories but, services have already turned up. The German consumer seems to be missing in action according to retail sales, but perhaps that’s because they went somewhere warmer, and their spending is on services rather than goods.
European consumers had continued to add to ‘Covid piggy-banks’ in the face of a series of crises, which are only now starting to recede. We see the opportunity for a virtuous cycle as falling inflation means European consumers regain confidence which encourages them to spend some of their accumulated savings, so further boosting the economy and confidence.
Wages are likely to rise strongly in Europe, with indexing and other backward-looking wage awards giving a further boost to consumer spending power.
Consequently, the ECB’s job is not done. Indeed, wage growth is forecast to rise further to 4% over 2023, so we expect a succession of interest rate hikes through the rest of the year.
Falling prices for natural gas and the strength of sterling are the main reasons that I’m confident that inflation will hit 3% by year-end. The latest inflation figures reflect the increase in the energy price cap of 200%. By the end of this year, that number will be negative. Reduced import prices will further help and encourage a moderation of wage demands and interest rate hikes.
As in Europe, we’ve seen an extraordinary period where real incomes fell but people have saved more. This was the reality of the record-low consumer confidence figures and the fear felt in the face of successive crises.
We see the opportunity for a virtuous circle to replace this. Recovering consumer confidence and spending boosting the economy and feeding back into improving consumer confidence. This would be easily financed from the accumulated consumer savings, including the still unspent ‘Covid piggy-banks.’
The rise of mortgage rates is a key headwind, a drag on consumer incomes and confidence, and one reason why the UK might underperform Europe. A 5% decline from peak prices is already in the figures and we think this is likely to be extended to 10% before we see a recovery.
We are positive on Treasuries, neutral on equities and negative on the US dollar.
Real interest rates on 10-year Treasuries are up over 1%, compared to the pre-Covid average of 0.5%. If inflation expectations remain under control, as they have done so far, then we see value in Treasuries, Gilts and, to a lesser extent Bunds over the next year.
While equities have been boosted by reports of results beating expectations, this is against a background of a resilient economy and previously slashed expectations. Investors are still more pessimistic than analysts for the year ahead on the basis of a recession in the US this year.
Corporate profit margins have already come under pressure in the US, a marked difference from Europe and the UK where margins have expanded. Therefore, we don’t like US equities, but are neutral overall. We prefer UK and European equities.
If the US is cutting interest rates at the end of the year, while the ECB is still raising rates, then European rates will be higher than in the US. That’s a dramatic development with implications for the US dollar and beyond.