Financial markets saw a quiet week in the run up to the Easter break but the past few days have been a lot busier with the usual start-of-month deluge of economic data.
Much of it has given further weight to the argument that central banks need not hurry to cut rates given economies are holding up well, in the case of the US, or showing signs of recovery, as seen in the UK and eurozone. After the broadly dovish narrative from the central banks in their week of meeting in late April, the past fortnight has seen a little more pushback from central bank speakers, with market expectations for rate cuts in the coming months diminishing further.
Let’s start with the economic data and the Purchasing Managers Index (PMI) surveys which gave encouraging signals that the drawn-out slump in manufacturing is coming to an end. The PMI surveys are a diffusion index, and a level above 50 implies expansion; conversely a level below 50 points to contraction. In the US, the manufacturing survey has been below 50 since October 2022, similarly the UK PMI manufacturing survey has been in contraction since August 2022. Both the US and UK posted PMI manufacturing numbers above 50 in March. The eurozone remains a laggard however, with German manufacturing still very much in the doldrums and suffering a hangover from the lack of cheap energy that used to flow from Russia. Without a German recovery, the eurozone will struggle to escape from the sub-50 PMI manufacturing level that began in July 2022. Within the US manufacturing data there were signals that inflationary pressures have not abated completely, with ‘prices paid’ well ahead of expectations, and the highest level since the summer of 2022. The PMI services data showed less dramatic moves, with the US and UK fairly steady (and above 50) but the eurozone was notable for positive reasons with the strength in the periphery making up for weakness in France and Germany. This dragged the eurozone composite PMI figure into expansion for the first time in 10 months.
The stronger PMI data again highlighted the resilience of economies to interest rate hikes, and indeed for all the talk of economic ‘soft landings’, ‘hard landings’ or ‘no landings’ the narrative has the potential to move on to focussing on a cyclical recovery. The US economy has endured nothing more than a soft patch so far as a result of rate hikes, while the UK and eurozone have suffered the shallowest of recessions. The Japanese recession has already been revised away with updated data. Western economies have failed to see any notable increase in unemployment, and wage growth remains a concern for the central banks. With economies in reasonable shape against a backdrop of higher interest rates, continued strength in the data allows central banks to maintain interest rates at current levels to ensure that the final push in getting inflation down to target is successful. As a result, market expectations for rate cuts have shifted considerably over the first quarter, something equity markets appear to have coped with a lot better than bond markets. At the start of 2024, bond markets were pricing in six rate cuts in the US and eurozone, and seven rate cuts in the UK. At the end of the first quarter, expectations across the US, UK and eurozone were for only three cuts, so expectations have shifted significantly as markets have priced out anything other than a soft landing or even no landing in the US and digested the gentlest of hard landings in the eurozone and UK. The economic potential remains the strongest in the US, where the Biden administration is set to do ‘whatever it takes’ to keep the economy ticking along ahead of the November election. While getting policy through Congress looks near-impossible, the government can make use of liquidity from the Treasury, make tax cuts, forgive student loans and even use the Strategic Petroleum Reserve to try and keep a lid on petrol prices. Whether there’s a post-election economic hangover remains to be seen, but in the near term the US economy should stay in solid shape.
The central bank commentary from this side of the Atlantic has been light but comments in the US have driven expectations that it will likely be the European Central Bank or Bank of England that cut interest rates first. Federal Reserve (Fed) Chair Jay Powell said he expects inflation to fall and while the road was “sometimes bumpy”, inflation was heading towards the Fed’s 2% target. Powell’s comments came after PCE data (the Fed’s preferred inflation measure) showed inflation at 2.5% in February, up from 2.4% in January. Powell described the PCE data as “pretty much in line with our expectations” but notes “we don’t need to be in a hurry to cut”. On Wednesday this week Powell added “we have time to let the incoming data guide our decisions on policy…the outlook is still quite uncertain, and we face risks on both sides”. Some of Powell’s colleagues were more direct in their views that there is no urgency to start cutting policy. The Atlanta Fed’s Raphael Bostic suggested he expects only one rate cut this year and said the Fed could be patient if the economy was holding up. Fed Governor Christopher Waller said there is no rush to lower interest rates and emphasised recent economic data warrants delaying or reducing the number of cuts seen this year. Waller called the recent inflation figures “disappointing” and said he wants to see “at least a couple months of better inflation data” before cutting. Waller noted a strong economy and robust labour market as further reasons why the Fed has room to wait to gain confidence that inflation is on a sustained path toward the 2% target. San Francisco Fed’s Mary Daly said that “right now growth is going strong, so there’s really no urgency to adjust the rate”. Cleveland Fed’s Loretta Mester said she still saw three cuts this year but “it’s a close call” and “at this point I think the bigger risk would be to begin reducing the funds rate too early”. Minneapolis Fed Chair Neel Kashkari went even further, raising the prospect of no rate cuts at all this year.
The first quarter of 2024 has been a rewarding one in many equity markets. Investors should be mindful, however, that equity markets are yet to see any significant form of significant consolidation this year though the past few sessions have seen some hints of weakness. With sentiment and complacency levels elevated, any negative headlines, most likely on rates, inflation, or geopolitics, could be the catalyst for some profit taking and more of market pullback. The fact that underlying economic fundamentals remain benign however, should help sentiment. Bond markets appear a little more circumspect, trying to filter out the ‘noise’ from the central banks and waiting for action on interest rates. Once we see higher confidence that rate cuts are imminent, the darker clouds over parts of the bond market should lift somewhat. But in the meantime, we can take comfort in the knowledge that while bonds may be having a tougher time, the reason for this is economies are proving resilient to higher rates and in the case of the US, continuing to grow, and for the UK, showing some of Norman Lamont’s ‘green shoots’.
