Stronger for longer?

A good week for

• US equities rallied +1.5% in sterling terms
• Emerging market equities crept +0.4% higher in sterling terms

A bad week for

• Equities weakened across the UK, Europe and Japan in sterling terms
• Bonds weakened in local currency terms, with UK gilts leading the way down (-2.5%)

UK inflation

UK bond prices suffered last week as a stronger-than-expected inflation report stoked expectations of more monetary tightening. April consumer price inflation came in at 8.7%, a sharp drop from the 10.1% annual rise in March, but ahead of expectations of a decline to 8.2%. As expected, the sharp drop in the Consumer Prices Index (CPI) was mainly due to energy. In April 2022, the Ofgem price cap was increased by 54%, pushing up inflation, and in April 2023 this rise exited the annual inflation calculation. Other components of the CPI were stronger than expected, including food inflation which remains at 19%. Services inflation actually accelerated to 6.9% from 6.6%, ahead of the Bank of England’s own forecast, driven by telecoms, social rents and insurance premiums. Inflation is still expected to fall sharply this year, with more anniversary effects bringing down headline inflation toward 4% by the end of the year, but the strength of core inflation is a concern for the Bank of England. This increases the likelihood of further monetary tightening, a view shared by the market. Futures prices now indicate interest rates peaking at 5.5% in December 2023, compared to a peak of 5% in September, as was expected at the end of April.

UK energy

Looking ahead, energy prices are expected to continue to have a cooling effect on UK inflation. The UK’s energy regulator, Ofgem, announced that the June retail price cap will be £2,074. This will see the cap fall below the level of the Government’s Energy Price Guarantee Scheme (EPG), and will see annual utility price inflation fall to 5% from 27% in April and 96% in January. The price cap is expected to continue to fall throughout 2023, bringing headline inflation lower.

US fiscal policy

US lawmakers have reached an agreement on a proposal to raise the cap on US government borrowing, known as the debt ceiling. The US government is expected to reach the current legal limit on its government borrowing in June, with Treasury Secretary Janet Yellen giving 1 June as a “hard deadline” for extension. Democrat and Republican leaders have successfully negotiated the conditions to extend the debt limit beyond the next presidential election. This includes flat non-defence government spending for two years, followed by a 1% rise in 2025. Unspent funds made available under Covid-19 relief measures will be clawed back in the agreement, and nutritional assistance programmes will also be made moderately less generous. President Biden and Republican House Speaker Kevin McCarthy must now persuade congress members to vote for the proposal. Should they be unsuccessful, the Treasury could buy time by implementing a partial shutdown of some government services, in order to continue to make interest payments on US debt. While brinkmanship is likely to cause market volatility, we expect a resolution, though a cut to fiscal spending is likely.

US monetary policy

Minutes of the May Federal Open Market Committee (FOMC) meeting revealed division and uncertainty, stating that “participants generally express uncertainty about how much more policy tightening may be appropriate.” In addition, “some” participants indicated that an “unacceptably slow” cooling of inflation necessitated further rate hikes. At the same time, “several” participants noted that weaker growth expectations meant “further policy firming after this meeting may not be necessary.” The committee was able to agree that bank stress “contributed to some tightening in lending standards … especially among small and mid-sized banks.” The evolution of credit conditions, and the toll it takes on growth will likely determine if the Federal Reserve decides to tighten further. Business surveys indicate a material deterioration in credit conditions, dating back to the start of the year.

Business conditions

May’s business surveys continue to indicate a mixed picture for the global economy. Services indices are still in expansionary territory, while manufacturing surveys remain weaker, and are signalling contraction. This likely reflects generally weaker global activity in 2023. The unwinding of global supply chain difficulties may also be having an impact, resulting in companies de-stocking and weaker goods demand.

Important information
The information contained in this article is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This article is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites.