Tightening Until Things Break

Economy - Jobs are next

FedEx (FDX) missed revenue and earnings expectations for the most recent quarter and pulled guidance for the fiscal year, citing bad global macro conditions. The CEO remarked that the numbers suggest that a worldwide recession is coming. Indeed most indicators continue to imply global economic weakness ahead, particularly in the United States and Europe. China is arguably already on a downcycle, but its current zero-covid policy and drought-related power generation issues limit its recovery prospects. Plus, the minor issue of a property-induced Chinese banking crisis remains. The Renminbi has joined nearly every other global currency, showing weakness compared to the rampant USD.

The Atlanta Fed’s GDPNow estimate for Q3 has dropped significantly to 0.5% annualised real growth in the United States. Most sell-side commentators are forecasting a negative outcome.

Employment, the last shoe to drop, may already have done so. Bulls (including Jay Powell and President Biden) point to the US labour market as a continued sign of confidence. However, over the last four months, while the non-farm payroll numbers indicate that 1.7m jobs have been created, the household jobs survey suggests that the US economy lost 170 000 jobs. One of these surveys will be wrong and non-farm payrolls are subject to greater revision, particularly at turning points.

Inflation, Rates & Yields - Only way is up

By every measure, US price inflation measures for August came in above expectations, even though down from the peak. The headline and core figures were notably above expectations month over month and year over year. In other words, it’s falling, but not nearly as fast as expected.

Lagging data is part of the problem (owners’ equivalent rent particularly). But the fear remains that inflationary expectations have taken hold.

The rational base case assumption is that inflation will be higher for longer, which bond markets are starting to factor in.

US Treasury yields are now at their highest for over a decade, and US mortgage rates are above 6%. Expect collateral damage among private-equity-backed credits and lower real estate values in the coming months.

The cause of our inflation was the rapid increase in broad money supply in 2020/21, boosting demand for goods and services without boosting the supply of goods and services. This created supply shocks. As markets adjust, this price inflation is ultimately transitory in rate of change terms. But prices settle at a higher level due to more money permanently being in the system. As someone once said: Inflation is always and everywhere a …. [thanks Milton, Ed.].

Monetary Policy - Let's break things

Fed and other Central Banks are determined to tighten until something breaks, maybe until many things break. They are prepared to be seen as too hawkish rather than too dovish, more Paul Volcker, less Arthur Burns. So we will continue to witness monetary tightening into a slowdown. It could be messy.

Markets now indicate that US rates peak at over 4% by 2023 and then remain elevated.

Ironically, Fed pivoters, in full retreat, are now probably more likely to be proven right.

Energy - Prices higher for longer

European energy markets have been in turmoil. Most retail energy markets have broken and been supplanted by some form of government intervention.

European natural gas remains volatile and highly elevated.

The traditional way markets ration scarce resources is via the price mechanism. Being able to outbid the rest of the world for LNG, Europe seems to have refilled its storage capacity and (probably) avoided the worst winter scenario. But there will be collateral damage in the shape of industrial demand destruction, not to mention ESG sensibilities.

The oil price has been weakening but remains at historically high levels. With the dollar at extreme levels, the oil price in Euro or Yen remains even more elevated. Central bank tightening and China’s zero-covid policies are both dampening demand. With the US boosting supply from its Strategic Petroleum Reserve, the oil price looks poised to rebound into Q4. The Biden Administration wants gasoline prices under control during the midterm elections. Some of these factors will unwind (the SPR is almost exhausted) as we move into Q4 and OPEC+ shows no sign of helping with any incremental supply.

Longer-term structural oil supply limitations remain present (US rig count numbers remain subdued, for example) with growing emerging market demand. A recession with high oil prices (stagflation)could be an enduring reality.

Geopolitics - Ukraine 1, Russian 0

Although the fog of war makes assessment tricky, it does appear that Russia is having difficulties in Ukraine, with its allies and potentially even among its own hierarchy.

Ukraine has scored a significant tactical military victory against Russia in recent weeks. This does not secure ultimate triumph, but it does make it much harder for the West to slack off in its support of Ukraine.

The West’s attempt to reduce Russian exports has largely failed. The world needs Russia’s commodities, and emerging markets have ignored Western calls to boycott Russia. However, the West’s financial support of Ukraine, and the West’s restriction on exporting needed technology to Russia, have been more successful.

Currencies - All about the $

The USD wrecking ball continues to dominate global currency markets. Everything else looks weak by comparison, now including the Renminbi.

UK - Risky changes

With the state funeral out of the way Liz Truss and her new government return to their daunting inboxes. The strategic direction is clear. Growth, not levelling up, energy security, not climate change, and no more Oxford commas (oops).

This woman is under enormous pressure, without a popular mandate for these strategic changes, with little time before the next election and global investors watching her every move. Expect a dizzying array of new policy proposals to boost the UK’s supply side, and expect howls of opposition from the orthodoxy (BofE, Treasury, most media channels) as Trussonomics takes shape. Unlike her predecessor, she seems prepared to take tough decisions and be unpopular. It is a risky strategy with the odds stacked against her. But the last time the UK had a female PM with a strong sense of conviction who took charge amid an energy-induced economic crisis was ultimately in power for 11 years. Just saying.

Holiday Idea - Yen to visit Japan

And finally, if you are wondering where to go for your next holiday, then maybe it’s time to visit Japan. The Yen is one of the few major currencies to have weakened year to date relative to the £, and as the chart below shows, not many other people have been going there recently. Some COVID restrictions remain, but they are coming to an end shortly.

The post Tightening Until Things Break appeared first on Progressive.