Macro update - why are we waiting?

At 4% year-on-year in May, US headline inflation has more than halved from its mid-2022 peak of 9%. Headline rates in Europe seem also to have turned decisively lower, with big falls still pending later in the year as the energy price arithmetic works its way through (last week’s bounce in wholesale gas prices notwithstanding: they had fallen to less than 10% of last summer’s highs).

In both the US and Europe, prices will soon be growing more slowly than wages – on a 3-month view, as opposed to a year-on-year comparison, they probably already are – and squeezed spending power is about to get some relief. Meanwhile, transatlantic business surveys have softened, but not collapsed, and labour and industrial capacity seem still to be pretty fully employed: despite that squeeze, actual spending has in fact held up well. Even UK economists are a bit less miserable than they were. What’s not to like?

In one sense – the longest-term, biggest-picture one – not a lot. Or at least, not in the realm of economics: there are of course plenty of geopolitical, environmental and social rocks in the road ahead. But in terms of the macroeconomy, not only is the inflation cycle on the turn, but today’s cleverer chatbots (present company excluded) are a timely reminder that the secular gloom about productivity may have been overstated. And no, this does not mean that “The Singularity”, or mass unemployment, loom instead – we’ll revisit those misplaced worries in a future post.

So why aren’t we sounding more positive on stock markets? We have not been pessimistic of late, but we haven’t yet felt able to urge a significant addition to holdings. From our top-down vantage point we advised reducing positions early last year, and have largely sat tight since.

The reasons have varied – mostly shifting back and forth between the two tactical concerns of rising interest rates and falling corporate earnings, with banking worries (remember those?) the most recent instance of the latter.

What we see as residual interest rate risk is once again our main tactical concern. The Fed and the ECB have just confirmed that they have not quite finished tightening yet, with the ECB arguably looking most decisive of late (not that the euro has taken much notice yet). The Bank of England remains the least convincing of the big three Western central banks (apologies to the SNB and BoC), perhaps because its rate setting committee has less skin in the game, but even in Threadneedle Street it has been difficult of late to ignore the signs of resilience in the UK economy: rates are likely to rise further next week, and indeed might yet push above those in the US if the labour market remains tight (the money market is already betting as much).

And while the distance ahead is small relative to that already covered, we expect policy rates to trace a flatter, more plateau-like path when the tightening stops – in contrast to the sharper profile still priced into money markets. If we’re right about real wages being the cavalry set to arrive over the hill and rescue hard-pressed households during the second half of the year, then the impact of monetary tightening may remain underwhelming. Which will be good for growth, but bad for core inflation, which is already (unsurprisingly) taking longer to turn the corner than headline rates – and bad in turn for the chances of interest rate cuts further down the road.

So far, firmer stock prices largely reflect the excitement in the technology sector. Gains have been pretty narrow (though that does not mean they are without foundation, as noted). We doubt that the cyclical train has yet left the station.

Of course, we could be trying to be too cute here. We have written often about the difficulty (futility?) of trying to “time” the market. Arguably, if valuations are OK and the long-term outlook remains constructive perhaps we should just get on with it. But so many people have said so many strange things about interest rates in recent years that is it hard to believe that investors have fully digested a return to the old normal just yet.

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