Market and Economic for week ending 13 May 2022
Market and Economic Review
A week without central bank meetings didn’t give volatility a respite, as markets digested the prior week’s decisions with continued uncertainty. On Monday, without an apparent catalyst, the S&P 500 fell over 3% as investors perhaps started to adjust to a landscape where central banks were more focused on tackling inflation than maintaining easy financial conditions in the near term.
As widely reported, China has been trying to deal with a resurgence of COVID-19 cases and due to the initial government response to Western vaccines and lower uptake its own vaccine has resulted in a ‘zero COVID’ policy of limiting human interaction through rolling lockdowns. This hampers economic activity and metrics such as China exports have slowed sharply. Exports rose slightly (+3.2%) for the year to April, but remain dramatically lower than the 14.7% rise in March. Accordingly, inflation moderated early in 2022 and policymakers have been actively trying to stimulate the economy with targeted measures such as loan incentives in the damaged property sector. Annual inflation increased to 2.1% in April, ahead of the March reading of 1.5% and above consensus estimates, which was the highest reading since November last year. This was an amalgamation of increases in the price of food, transport and communication, where a combination of both demand increases and supply chain reshoring impacted prices. The latest producer prices reading reported at 8% for the year to April, as China tries to pivot to domestic production for certain goods, in an attempt to limit the damage from global commodity price spikes. Further monetary support is also being rolled out when required in an effort to maintain GDP growth targets.
In contrast, the US central bank has been trying to moderate inflation and the latest reading of 8.3% for the year to April won’t give them much relief, even if it was 0.2% lower than in March. On the one hand, used car price rises declined and energy price rises slowed to 30.3% compared to 32% in March, but on the other, food price rises increased to 9.4% and shelter accelerated to 5%. Shelter is a large part of the inflation basket so small rises result in a large impact, and the knock on impacts to wages and rents is a metric the Fed is keenly watching. If we see corresponding increases in these numbers, the wage/price spiral that has been dormant for decades may worryingly be showing signs of life. To give some context, inflation-adjusted hourly earnings were down -3.4% for the year, highlighting that wage bargaining has yet to result in meaningful wage rises. However this is a double edged sword, as declines in real wages may hurt economic growth if consumers tighten their belts.
Data from other regions exhibited similarities: Japan reported a -2.3% reduction in real household spending, the first decline since last December, while German inflation came in at 7.4% for the year to April, mainly boosted by the energy quandary facing the country with respect to imports of gas from Russia. The proposed six month EU ban on Russian energy imports appeared to fall at the first hurdle after Hungary objected to the proposition due to their heavy reliance on imported energy as well as their diplomatic links to Russia. This added a further catalyst for crude oil declines, where the commodity fell by $10 a barrel over two days. The ZEW Eurozone economic sentiment indicator reported -29.5 for May, still heavily negative but an improvement compared to -43 in April.
UK GDP contracted by 0.1% in March 2022, following the 15.1% decline in vehicle sales linked to supply chain issues. However, GDP rose 0.8% in the first quarter of 2022, below central bank’s forecast of 0.9% and market forecast of 1.0%. The increase in GDP signals a high point for the year factoring the cost of living crisis and squeeze on consumers spending. On a monthly basis, GDP is now 1.2% above pre-COVID levels in February 2020. The recovery was driven by increased spending on healthcare (+11%) since the start of pandemic. However, consumer services remain 7% below their pre-COVID level. PPI in the US increased by 0.5% month-on-month, in line with market expectations, while annual PPI soared 11% in April, marginally above market expectations of 10.7%. The data suggest that high inflation will remain a burden for consumers and businesses in the months ahead.
Next week, we have retail sales from the US, UK and China, which may signal whether consumers are tightening their belts, as well as UK/Japanese inflation and unemployment, Eurozone GDP and sentiment surveys such as the NY Empire manufacturing survey, Philly Fed business survey and US home sales.
One of the first emerging market countries to experience serious upheaval from the food and energy and crisis is Sri Lanka, where it is experiencing extreme economic and political pressure as the rupee plunged to record lows and their population of 22 million suffers from power cuts, food and fuel shortages. The prime-minister tendered his resignation and fled to a naval base while protesters looted and burned down many buildings, including his residence. Mismanagement by the government, after a series of tax cuts and significant loss of revenue from tourism that shrank during the pandemic has left the country in a severe debt crisis. A ban on imported fertilisers resulted in falling crop yields, threatening further food shortages. Sri Lanka is heavily reliant on imports and their foreign reserves have fallen to $50 million, which is little to cover even a days’ worth of imports, highlighting the significance of the crisis.
Tactical review & outlook
Central banks are becoming increasingly hawkish, demonstrating more urgency in withdrawing asset purchase programmes in addition to front loading interest rate increases. Market pricing of inflation suggests an expectation that inflation will fall back once again, but the key question that remains is whether the swift withdrawal of stimulus will dent economic growth, potentially causing a recession. However, this is complicated by the economic side effects of the continuing Russia-Ukraine conflict, with its material impact on inflation and supply chains that had already been hit by the COVID crisis. Macro data from China has shown some growth weakness. As a result, we believe uncertainty and volatility will remain high.
We are currently running a small overweight position in UK and US equities (providing diverse sector exposures). We also have a moderate overweight in Alternatives and Property, which we think can act as good diversifiers, less directional in nature, and also to benefit from potential inflation protection characteristics. Where funds do not hold either Alternatives or Property, we maintained a beta-adjusted exposure to equities in its place. The overweight positions are entirely funded by a Fixed Income underweight (rather than partly through cash). Where possible, this is a diversified underweight of UK/US/European Fixed Income (noting that some funds have more limited regional exposures). We will continue to monitor the market for both opportunities and threats from here.