Inflation is moving in the right direction and the US is seemingly at or near peak interest rates. What about the UK and Europe?
We expect US rate cuts by the end of the year, but not until 2024 in Europe
In terms of inflation, the US seems to be on track. The collapse in headline inflation is welcome, but more importantly core inflation is also trending down. If wages follow suit, as we see clear signs of them doing, then the US could see a soft landing.
Europe and the UK are lagging, with the outlook for growth and inflation intertwined as sticky inflation means more interest rate hikes and so more risks to growth.
Overall, we are upgrading our expectations, even as a mild recession remains a risk. Government bonds remain attractive, but the equity outlook has improved.
Figure 1: US consumers were spending ahead of real income
Source: Columbia Threadneedle Investments and Bloomberg as at 25 July 2023. Image – Piqsels.
US on course for ‘immaculate disinflation’
With headline inflation down to 3.0% already, the Federal Reserve appears to be in sight of its target.
While core inflation is still 4.8%, that is also coming down. Our forecasts show that the key rental inflation component is headed towards 4%. That still leaves wage inflation at around 5%, when it needs to be under 4% for the Fed to hit its overall inflation target. But recent data shows that firms, with profit margins being squeezed, are no longer paying up for staff.
With low headline inflation meaning that lower wage rises still boost purchasing power, so encouraging moderating pay demands, we think that the US could indeed be headed for a soft landing.
Firms no longer losing staff to higher paying rivals
Figure 2: Wage inflation % change year on year
Source: Bloomberg and Atlanta Federal Reserve, as at 25 July 2023
Major weak patch in Europe
Surprisingly bad economic data for Europe has persisted, with the Eurozone in technical recession. Manufacturing is clearly suffering more in the current downturn, which is a larger element for the European economy.
European consumers, despite becoming less gloomy, remain reluctant to spend accumulated savings, unlike those in the US and increasingly in the UK.
While further mild recession remains a risk for the undynamic European economy, we still see a path to recovery. European consumers will at some point start spending some of their accumulated savings, while the manufacturing cycle will rebound as the global economy recovers.
PMIs edge down with notable weakness in Eurozone
Figure 3: Composite PMI indices
Source: Columbia Threadneedle Investments and Bloomberg as at 25 July 2023
UK an outlier on inflation ... but improvement on the way
The disappointing UK inflation figures are driven by the lagging impact of higher import costs, which take a full twelve months to work through the supply chain. Last year’s weakness of sterling has been replaced by strength, meaning a 2% boost to inflation will reverse this year, with another 1% decline set to come through in 2024.
Another positive factor is that, judging by PMIs, the UK economy is actually doing all right, on par with the US, and certainly better than Europe, despite all the negativity in the news headlines.
While there is much focus on the current pain in the housing and mortgage markets, we think that mortgage costs have likely peaked and that, while house prices will decline by around 10% from their peak, the worse is passed, leaving prices still above pre-Covid levels.
Figure 4: Boost to inflation from weak £ in 2022 set to reverse
Source: Columbia Threadneedle Investments estimates. The data assume an impact on sterling – measured by an equal geometric weighted average versus the euro and US dollar – whereby a 3% appreciation reduces the CPI by 1% gradually over 12 months with a 3 month start delay. Sterling is assumed to be constant at its level on 24 April through the rest of the year. Estimates and forecasts are provided for illustrative purposes only. They are not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
Equity outlook has improved, and Japan looks notably attractive
We are much more constructive on the outlook for equities. While our expectations for S&P 500 earnings are still below the market consensus of forecasts, that is in-line with median investors’ expectations which are also rightly sceptical of current analyst forecasts.
We prefer the UK equity market, which is cheap and out of favour, compared to the US equity market which is expensive and where a lot of potential benefits from AI have been discounted.
We like Japanese equities, where profits are rising and returns to shareholders are increasing. Measured by dividends and share buy-backs, the percentage returned to investors from the TOPIX index is now on a level with that from the S&P 500.
Government bonds appear attractive, given the high risk-free yields available. Those yields should come down as inflation trends lower, towards central bank targets, triggering interest rate cuts.
A more positive view of the US economy, combined with a weaker trend for the Eurozone, means that we have closed our successful bet against the US dollar versus the Euro.
Model forecasts negative earnings growth in US
Figure 5: S&P 500 EPS (Y/Y)
Past performance is not an indication of future performance.
Source: Columbia Threadneedle Investments, Datastream and Bloomberg as at 5 June 2023. EPS = earnings per share. Estimates and forecasts are provided for illustrative purposes only.
They are not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
