Markets breathe a sigh of relief over the lack of further escalation in the Middle East – but the focus returns to the sticky US inflation theme
We have seen some respite from the recent downwards momentum as a lack of Federal Reserve speakers has allowed investors to focus on a solid start to Q1 reporting season and breathe a sigh of relief that what turned out to be a limited Israeli attack on Iran last Friday. It appears to have marked an end in the recent escalation rather than the catalyst for further attacks. That said, volatility in bonds and equities has continued as concerns over the Federal Reserve’s ability to cut rates against a backdrop of sticky inflation continue to weigh on sentiment.
This time last week there was plenty of concern over the size and scope of the Israeli attack on Iran but as the day progressed it became clear this was a very limited assault, with Iran downplaying the attack. They likened the weapons involved to “toys that our children play with”. Iran’s foreign ministry spokesman said that Israel had received “the necessary response at this stage”, messaging that suggested Iran saw the attack as inconsequential, and reduced worries over a further escalation in the short term. As a result, the oil price fell back, and safe havens such as gold gave back some of their strong recent gains, which in the case of gold had taken the price to a nominal all time high. The oil price now sits unchanged from the level before the Israeli strike on an Iranian diplomatic compound that caused the recent escalation in tensions.
We have had no updates from the Federal Reserve which has been something of a relief for markets given the messaging was consistently pointing to rates staying higher for longer. However, the inflation data has continued to surprise to the upside as we saw in the Q1 GDP data yesterday (more on that shortly). The Fed is now in ‘blackout’ ahead of their meeting on 1st May and we watch with interest for the March PCE data in the US today – this is the Fed’s preferred inflation measure, and if it echoes the CPI data, which has surprised to the upside for the third month in a row, markets will become even more convinced that the Fed is not likely to be cutting rates for many months to come. Rate cuts appear far more likely this side of the Atlantic, with the European Central Bank leaving the door wide open for a cut in June (though what comes next is up for debate) and the Bank of England likely to be cutting rates by late summer so long as the expected falls in CPI from energy prices are not offset by continued strength in wage data and services inflation. Bank of England Chief Economist Huw Pill expressed caution on Tuesday, saying there is still a “reasonable way to go” before he is convinced that underlying price pressures are under control. Pill said that “there are greater risks associated with easing too early should inflation persist rather than easing too late should inflation abate”. Markets are currently not expecting the Bank of England to cut rates until August, with one further rate cut by December.
In terms of the economic data, the week has seen the flash PMI data updated, and after the strong showing in March, April’s numbers in the US and UK for manufacturing retreated back into ‘contraction’ while eurozone manufacturing remained weak with limited signs of a recovery in German manufacturing. The overall data was more encouraging however, as the services sector, which dominates western economies, showed continued strength. This meant the composite PMI figure for the eurozone and UK climbed to the highest level since May 2023. In the US the composite data was a little softer, and while still in expansion, was the lowest level seen this year. The US published first quarter economic growth data which was the worst of both worlds, surprising to the downside on growth but to the upside on inflation. The US economy grew by an annualised rate of 1.6% in Q1, well below the 2.5% level expected. Meanwhile the PCE data showed headline growth of 3.4% and core PCE growth of 3.7%, both worse than expected. Excluding the sticky inflation in the housing sector, core services PCE was 5.1%. These numbers do not sit well with those hoping for Fed rate cuts, with market pricing now implying just 34 basis points of rate cuts this year, and the first cut in December.
We have had one major central bank meeting this week – the Bank of Japan. As expected, there was no change in policy, with the bank seemingly in no hurry to tighten policy further having made the shift away from negative rates back in March. The bank said it expects inflation to remain above or around its inflation target through to 2026 but the tone was seen as dovish, and as a result the Japanese Yen weakened further, to fresh 34 year lows against the US dollar. Expectations of market intervention to support the Yen are high given the Yen has now weakened through previous support levels. Given the huge interest rate differentials between the US and Japan, this is a trend that is hard to get in the way of.
The economic data (and recent Federal Reserve speeches) should make it abundantly clear to market participants for now that in the US at least rate cuts are highly unlikely in the near team. US inflation is not coming down quickly enough and the economy, notwithstanding the weaker than expected Q1 GDP print, is still in solid shape. Corporate earnings at the headline level look robust, though there is a skew towards the mega cap companies performance masking weaker numbers elsewhere. So, the outlook for markets points to some uncertainty, not least given the strong run we have seen since October. Bond markets are yet to get comfortable with the thought of US rates staying on hold, maybe until next year, while equities have so far, despite a mild pullback, shown more resilience. We expect a slightly more volatile environment, with markets laser-focused on inflation related data points and central bank language in the near term.
Have a good weekend,
Regards,
Anthony.
