Recent economic data have been improving across the world. The number of economic surprises – where data releases have differed from consensus expectations – have been positive in almost every country, developed and emerging markets alike. In addition, inflation has been sticky. Yes, headline numbers have been coming down but core inflation has been stable – or even picking up, as is the case of Europe. Meanwhile concerns that the failure of three US banks would trigger a full-blown credit crisis have abated.
So where does this leave the outlook for interest rates? Starting with the US, we expect a further increase in US interest rates when the FOMC meet on 3 May. Decisions after that will be data dependent and that data may well suggest little or no further increase.
The recent stronger US economic data can be traced to cost of living adjustments (COLAs) which lifted social security payments in January by 8.7%. Those effects are receding and although a credit crunch may have been averted, a credit squeeze is clearly underway. Moreover, the collapse in house sales is feeding through to declining spending in related areas. US companies have been suffering a margin squeeze, they’ve already cut CAPEX and reduced hiring should follow. I expect a US recession by the end of the year.
Europe by contrast is still enjoying the benefits of declining energy prices. Consumer and business confidence are improving. Core inflation is still firm and with unemployment low, the ECB will likely continue to raise rates. Indeed, they could be higher than those in the US by the year’s end, if my recession forecast is correct and the Fed moves to cut rates in the US. A big turnaround indeed.
Prospects for the UK are interesting. The pessimism over the autumn and winter is now seen to have been greatly overdone. We have our own equivalent of COLAs – social security payments here are going up this month by a whopping 10.1% so expect consumer spending to be firm over the spring.
Don’t get me wrong, this is nothing like a boom but it is continued growth and a very different background from the one expected by the Bank of England (BoE). So interest rates are headed higher here too. But perhaps not much further. Although inflation remains far too high here, wage inflation in the private sector has slowed markedly, from 7% annualised three months ago to just 1.2% on the latest numbers. We get more data this week and even if it goes up a little, that would still give the BoE encouragement that inflation – due to fall dramatically by year end due to base effects – could move sustainably towards their 2% target in 2024. They should be able to look through the upcoming boost to consumption all too aware of the headwinds from the housing recession.
What does all of this mean for financial markets? An end to US interest rate hikes should boost risk assets but the prospects of US recession go the other way. We are neutral on equities. Better economic data usually translates into better earnings and that probably means European equities outperform those in the US. It also points to renewed dollar weakness versus the euro. Sterling should also benefit but not by as much. And UK equites, still relatively cheap, might also outperform. Economic recovery and a weaker dollar should also boost EM equities.
It all looks like a rather dull background but that would be a welcome change after all the excitement in March.