This week has seen financial markets driven higher by positive news on inflation from both the US and the UK, with CPI easing by more than expected on both sides of the pond
This has furthered the narrative that central banks are done with hiking rates, with expectations increasing that rate cuts are now on the horizon, with the US economy heading for a ‘soft landing’.
In the US, the inflation data for October showed CPI at 3.2% year on year, slightly below expectations of 3.3%. Even though the data was only marginally better than expected, this triggered a significant rally in equities and bonds, with the S&P500 index seeing its best session for six months, while the small cap Russell 2000 index was up 5.44%, for its best day in over a year. In bonds, we saw significant falls in yields across the curve, while the US Dollar index fell by 1.5%. In terms of the data, core CPI (which excludes food and energy) also eased, to 4.0% year on year, again lower than expected. Futures markets, that were pricing a 30% probability of another Fed rate hike before the CPI data was released moved sharply to price out any chance of any further rate hikes and raising the probability of a rate cut by May to 86%.
In the UK, inflation in October eased sharply, to 4.6% year on year, below the 4.8% expected, and well below the 6.7% pace of price rises recorded in September. This sharp drop, to the lowest level since October 2021, was well anticipated as the energy price rises from last year fell out of the data, and gives the Prime Minister something of a boost, in a very busy week, having met his promise to halve inflation before the end of the year. Core CPI fell back to 5.7%, and services CPI, which is closely watched by the Bank of England, eased to 6.6%. The fall off in gas and energy prices is worth noting – gas prices were down 31% on last October, with electricity costs down 15.6%. However, compared to October 2021, gas prices are still up 60% with electricity prices up 40%.
Elsewhere in the economic data, the monthly ‘data dump’ from China delivered mixed signals. It was positive to see solid retail sales data, up 7.6% year on year, as well as Industrial Production up 4.6%. Both were ahead of expectations. The property sector continues to weigh on the wider economy however, and while fixed asset investment saw growth of 2.9%, this was below expectations. The UK reported employment data, with the unemployment rate unchanged at 4% and payrolls increasing by 35,000. Weekly earnings outpaced inflation for the fourth consecutive month, rising by 7.7%. Retail sales data for the UK published this morning showed a significant drop in sales in October, with a decline of 0.3% against expectations of an increase of 0.3%. This left retail sales down 2.7% compared to October last year. Maybe higher interest rates are starting to bite.
Outside of the economic data, UK politics has seen a dramatic few days, with a cabinet reshuffle seeing the expected departure of the Home Secretary and entirely unexpected return to front line politics of former Prime Minister David Cameron, who was appointed Foreign Secretary. The Chancellor, Jeremy Hunt, remains in his post – a change in Chancellor the week before the autumn statement would likely not have gone down well in markets. The market moving event, if anything, will be the autumn statement next Wednesday, with the government hoping that revised forecasts from the OBR will allow them some wiggle room to announce some pre-election tax cuts.
Turning to geopolitics, and ahead of the Asia Pacific Economic Conference, Presidents Biden and Xi met in San Francisco for talks aimed at thawing relations between the two countries. Biden described the talks as “some of the most constructive and productive discussions we’ve had”. President Xi said China has “no intention to challenge the United States or unseat it…China will never pursue hegemony or expansion and will not fight a cold war or a hot war with anyone”. Time will tell if these talks herald a period of less adversarial relations between the two powers.
We are now at an interesting juncture for the central banks – the Bank for International Settlements used a line, since repeated by Andrew Bailey of the Bank of England, that the “last mile of tightening is the most difficult”. This is where we are right now. Financial markets had already concluded that the Fed, BoE and ECB were “done”, with the most recent round of CPI data reinforcing this narrative. The central banks continue to talk up the prospects for ‘higher for longer’, wanting to maintain their credibility and ensuring that inflation is well and truly heading back to target, and staying there.
Mindful of the historical evidence that inflation tends to come in ‘waves’, they are reluctant to shift to an easing trajectory, or even be seen to be contemplating cuts, at a point where inflation remains above target, with core inflation and wages still at levels that give the central banks plenty of discomfort. But the direction of travel in the data means financial markets are already beginning to price in the start of a rate cutting cycle, with some trading days seeing an ‘everything rally’ as a result. Last week Christine Lagarde, ECB President was quoted in the FT as saying inflation would come down to 2% if interest rates were kept at their current levels for “long enough” but “it is not something that means in the next couple of quarters we will see a change”.
Central banks do not want tight financial conditions to be undermined by equities and bonds rallying too hard – this will undo some of the impact of recent rate hikes. Equally, central banks are aware that not all of the impact of the hiking cycles have yet fed through to economic activity, and particularly in the UK and eurozone, with growth already so weak, there remains a considerable risk of economic growth turning negative. The US, for now, appears to have achieved the near impossible of strong growth, falling inflation and unemployment barely budging, but it is worth remembering the US was far less impacted by the energy shock last year than was suffered in the UK and eurozone. The ‘soft landing’ narrative continues to dominate in the US.
The next few months for the central banks will be tough as they continue their fight against inflation, a battle which markets have already concluded has been won and balance any lingering concerns over inflation with the consequences of the interest rate hikes that are still to fully impact on the economic data. Meanwhile, do financial market participants think we’re heading back to the low rates environment that created such excesses in the past decade? You can imagine why this would be so positive for risk appetite but bear in mind where interest rates are now is fairly ‘normal’ when you look over history, and it’s the past decade which is ‘abnormal’. Interest rates in the UK between March 2009 and December 2021 averaged just 0.45%, but the average UK interest rate over the past 100 years is 5.24%. Today, rates sit at 5.25%. In the US, with data to 1954, the average rate is 4.6%, with rates currently 5.25-5.5%. Rate cuts may yet come, but investors should be mindful that money is unlikely to be almost ‘free’ again, as it appeared at some points in the years following the Global Financial Crisis and the pandemic.
Have a good weekend,