On Friday (7th of July) the US nonfarm payroll data missed expectations for the first time in a while. This suggests that the labour market is still strong but not as hot as before. US unemployment fell from 3.7% to 3.6% but the more telling figure is the increase in hourly earnings (4.4% vs 4.2% consensus). This increase in wages raised concerns that inflation might be stickier, however US inflation numbers released on the 12th of July came lower than expected and equity markets responded positively. At the same time, labour supply has been subdued for some time which signals less capacity for economic growth.
Despite the Federal Reserve’s pause in interest rate hikes at their latest meeting, it is reasonable to expect a few more rate hikes, or at least one more depending on the incoming data, given this wage growth. And, if rates continue to be higher, talk of recessionary risk will inevitably build.
Accumulated savings and wealth gains during the pandemic have been able to cushion a more serious drawdown in the economy so far, but a resumption of student loan repayments in the US could squeeze consumer spending further, particularly for younger households. Credit card borrowing has also risen to levels that are unsustainable given the current interest rate environment, and a return to a slower borrowing level could also hurt spending and confidence. However, given the current strength of the economy, central banks might be more successful, than initially thought, in achieving a more benign inflation, which would support both equities and fixed income in the year ahead.
This week (commencing 17th of July) is another important week as the new reports on consumer confidence and retail sales are released. Inflation expectations have moderated as energy prices have stabilised and supply chains globally have improved. The main obstacle to inflation decline remains wage growth, which is why it is critical to monitor the rate of new job openings.
In the UK, markets are now pricing in a 6.5% peak in UK interest rates by February 2024 and for rates to stay above 6% until the end of 2024. This means that mortgage owners will be getting higher mortgage rates, which is something that is definitely going to hurt.
Anyone with a fixed rate deal that is coming to an end and has to refinance soon, will see their mortgage payments rise significantly. This should put downward pressure on discretionary spending. Eventually, the level of interest rates currently being priced into the UK bond markets is likely to be painful for the economy. This could lead to rate cuts but until then we may see enough fixed rate mortgage deals expire, which can slow the economy and cool inflation.
Short dated gilt yields have risen above the 1-year fixed savings rate which means that UK government bonds are attractive again. The attractiveness of gilts is enhanced by the fact that they are exempt from capital gains tax.
Moving away from interest rates and inflation, international affairs have seen some ‘progress’ with regard to US-China relations. There has been some constructive dialogue between the two countries following Janet Yellen’s (States Secretary of the Treasury) visit to China. The US-China relations have been fragile for some time and whilst no specific agreement has been achieved, the two largest economies are no longer as hostile to each other as they were during the Trump presidency. The US still wants to put some brakes on the Chinese economy, as China remains the largest producer of metals used in microchip production. This poses some national security risks for the US. Yellen has been critical of China’s curbs on US firms and issues surrounding national security, but the two countries are realising that they need each other and are trying to find a way to cooperate and share global prosperity. Their issues will not be resolved any time soon, but it is important to separate national security from the economic picture. US-China relations are no longer the big power conflict we are used to seeing, and that is a positive development both for markets and geopolitics.