Last week, the Federal Reserve Bank paused its current interest rate hiking cycle – which did not actually come as a surprise to the market. However, there is every expectation that it will increase rates twice more later this year. Our position is that this is the right move – US inflation is on the way down and the US economy is showing signs of softening. We also expect the Fed to continue with its tough talk on bringing inflation back down to its target rate: it is keen to prevent financial conditions from loosening dramatically and wants to keep any further inflationary pressures under control.
In the UK, interest rate peak expectations increased last week as Bank of England Governor Andrew Bailey warned that wage pressures are still problematic. Indeed, UK wage growth recently hit its highest level ever (outside of pandemic times). This news – that wage inflation continues even after such an aggressive rate hike tightening cycle – triggered a sell-off in two-year UK gilts… and yields rose above the level reached in the immediate aftermath of the mini-budget crisis.
For some professional investors – both domestic and international – these higher yields are too tempting to pass up. This has created a positive backdrop for sterling, which hit a 14-month high against the US dollar. The UK economy actually grew marginally in April, buoyed by healthy trade in the restaurant, pub, travel and leisure sectors. Estate agents and housebuilders, however, did not enjoy such a good month. It looks as though the outlook for the construction industry will remain uncertain for some time: interest rates and mortgage costs are still rising, making buyers more cautious.
Many house buyers have also had their plans scuppered by banks pulling out of mortgage deals without notice. And significant hikes in monthly mortgage repayments – coupled with the overall rise in the cost of living over the past couple of years – are causing widespread distress.
While some prices have indeed fallen in recent months, helping to reduce the rate of inflation, recent data appears to suggest that the UK is far more inflation-prone than other similar economies, and that interest rates are likely to remain higher for longer.
Indeed, the release this Wednesday of last month’s inflation figure seems to support this: inflation is still running at 8.7%, unchanged from April and still much hotter than expected. Energy prices have been falling, but rising prices for air travel, recreational and cultural goods, and services – along with second-hand cars – have resulted in the largest upward contribution to the monthly change in both CPIH and CPI annual rates. This makes an interest rate hike on Thursday highly likely, adding yet more pain to UK households.
Although this current configuration of high inflation and higher interest rates is painful for many households, it's important to remember that in many respects, we are simply reverting to the way things were in the past – before the 2008 Global Financial Crisis. In fact, the average mortgage rate between 1995 and 2023 was around 5.63%. And over the past 50 years or so, interest rates in the UK have averaged just over 7%, while inflation has averaged just over 5%. It is only in relatively recent times that the cost of lending, interest rates and inflation have all been historically low.
What is worrying, however, is that the government has suggested inflation will be halved from its 2022 high of just over 11% by the end of this year. That would still leave it eye-wateringly high – just over its 50-year average. This is likely to be one of the key debating points between now and the next general election. If, of course, it remains sticky between now and polling day.
As far as the Eurozone is concerned, it has suffered two-quarters of slightly negative growth, meaning that it is now officially in recession. This can be attributed to a global trend of manufacturing activity contracting, although that has been slightly offset by stronger services activity.
Despite weaker growth and the ECB's somewhat negative forecasts for the rest of this year, it nevertheless hiked its key interest rate by a further 25 basis points, pushing the deposit rate up to 3.5%. The determining factor for raising its interest rate was... inflation. In its overriding statement, the ECB made it clear that the rise in its inflation forecasts reflects the Governing Council’s updated assessment of the inflation outlook. It would therefore appear that the ECB has joined a number of other bodies in adopting a “data-dependent” approach to its decisions.
In Asia, the reopening of China's economy post-Covid has not lived up to the hype. China has fallen into lockstep with the rest of the world: it now has a stronger services sector than a manufacturing one. Stimulus will therefore be needed, which is why the PBOC has announced a very modest interest rate cut of 0.1%. Further easing is expected.
Japan is also suffering from something of a gulf between its services and manufacturing sectors. The Bank of Japan has not yet tightened its monetary policy. While speculation mounts as to the BoJ’s next move, the yen has weakened. Japan's leading stock market indices, meanwhile, are substantially up, year-to-date.
At the forefront of debate is sticky inflation and what the leading global central banks are doing about it. But inflation is not the only live topic out there at the moment. The recent impact that AI has had on Wall Street has been simply staggering: a number of leading large-cap tech companies have benefited significantly from the market’s enthusiasm. We cannot predict the future, but there is every chance that AI is going be the driving force behind the next bull market which – I hasten to add – may possibly have started on 12 October 2022.
Wall Street has evidently been the focus of this year’s stock market recovery, even though the leading US indices have been propelled skywards by a number of mega-cap technology stocks. The AI story has obviously featured prominently. Indeed, the share prices of companies such as Nvidia have seen phenomenal gains. Nevertheless, we expect some bumps in the road ahead, and maybe even a meaningful pullback in stock prices at some point. But such bumps should always be seen as buying opportunities: the market will eventually broaden out both on Wall Street and globally, firmly rooting the new bull market.
