Michael Ford

Summary

• With equities up despite an upside surprise on the US consumer price index (CPI), it appears more likely that the recent equity sell off was about an unexpected spike in volatility, rather than an inflation scare.
• Next week, attention will shift to the latest purchasing managers’ indices (PMIs) (forecast to be slightly lower) and minutes of the last Federal Open Market Committee (FOMC) meeting (we don’t expect any real change).

Strategy review

Over the week, the US and emerging markets were the standout performers within equities.

Market and economic review

Markets: US CPI comes in a touch stronger-than-expected; bonds sell off, but the equity recovery continues

Equities started the week on a positive note, after the late rally in S&P 500 Index on Friday evening (UK time). Follow on gains were made around the world over the following few days, with Japanese equities the notable underperformer – linked to a strengthening Japanese yen (JPY. With the narrative focusing on rising inflation pressures, and the possibility of higher-than-expected policy rates, the safe-haven characteristics of the JPY were appealing to investors.

Nerves began to take hold as the release of the US January CPI number approached on Wednesday afternoon. It’s hard to remember a CPI number that has been so widely anticipated ahead of its release, and appeared to be so important to the future direction of markets. In the event, the core rate of inflation came in unchanged at 1.8%, when markets had expected it to edge down to 1.7%. Bond markets didn’t like that, but equities surprisingly rallied and the US dollar (USD) weakened.

The equity moves made sense to us, given core inflation remains at a very low level, and that over the medium term, economic developments should mean inflation rises, but only by an amount that will necessitate no more than the three rate hikes planned by the FOMC in 2018. Markets appear to agree, with the number of 25bp hikes in 2018 discounted only moving marginally higher to 2.9 since the CPI release. US equities seem to also like the latest fiscal boost planned by the Republicans (see below). More importantly, as the days pass, it appears increasingly likely that the recent equity sell off was largely driven by the fallout from stress in volatility structured products, rather than something more fundamental.

Bond markets have been a little more nervous, both about the inflation outlook and the increased bond supply implied by the government’s fiscal plans. While inflation is contained at low levels, the different perspectives of the bond and equity market can coexist. It’s only if inflation surprises significantly on the upside that something would have to give. This is not our base case. The weakness of the USD appears to reflect both the continued economic outperformance of Europe (which reported good GDP numbers this week – see the data section below), and concern over the US fiscal path.

Data: UK CPI surprise; Australian labour market changes; firm European GDP; weak US sales

With markets nervous about inflation, higher-than-expected core UK CPI prices were a disappointment, especially in light of the more hawkish comments made by the Monetary Policy Committee last week. But, inflation rates at the start of the price chain – input price and output price inflation – all fell fairly significantly, suggesting weaker CPI outturns over the next few months. Capacity constraints, linked to a lack of investment following the Brexit vote, might have an impact on UK inflation in the medium-to-long term, but we think the outlook is brighter for the shorter term.

In Australia, the closely watched National Australia Bank survey was better-than-expected on the headline numbers and the rate of unemployment edged lower (to 5.5%). That, in part, reflected a 16,000 increase in employment. The key point to mention here, though, is that all of that increase was linked to a rise in part time workers. Full time employment fell by 50,000. Given that, and the fact that the female participation rate increased, the inflationary impacts of stronger activity and higher employment are not as clear cut as they would at first seem. Indeed, Australia appears to be experiencing structural changes in the labour market that have been repeated around the world and helped keep inflation low.

In Europe, eurozone GDP grew 0.6% in Q4 2017, keeping the annual rate of growth at 2.7%. Germany was the standout, with a 0.6% quarterly increase, taking the annual rate of growth up to 2.9% from 2.8%. In addition, France reported a sharp drop in the rate of unemployment to 8.6% (from 9.6%). Such activity numbers are helping to keep the euro strong against the USD.

With all eyes on the US CPI release, not much attention was paid to weak US January retail sales numbers. In the normal course of events, this would have prompted a discussion on the sustainability of consumer spending. But, with the numbers probably weather distorted (large parts of the US were unseasonably cold in the month), and Q4 spending very strong, that didn’t really happen. One theory is that the cold weather explains the stronger-than-expected core CPI outturn. Remember, apparel prices rose by the largest monthly increase since 1990. That could plausibly reflect consumers buying cold weather clothes at unseasonably high prices.

Politics: more fiscal pump priming

The key political development during the week was the revelation that US President Trump was proposing a budget that would add $7tn to forecast deficits over the next 10 years (even with somewhat optimistic growth and, therefore, revenue forecasts). Key themes include reductions in social/healthcare-related spending, with spending increases for the usual Republican favourite, defence. In its current form, the proposal is unlikely to be passed (Congress controls the budget process rather than the President). But, with the majority of Republicans apparently happy to abandon their long standing support of fiscal probity, some budget deficit increases look likely. The big question here is, of course, whether or not the economy needs this boost. The fiscal purse strings are usually loosened at the low point of the cycle, rather than when growth is firm. As outlined above, it would seem that equities like this potential boost, regardless of the impact it has on the public finances, whilst the USD and bonds see it in a more negative light.

Elsewhere, South Africa’s President Zuma resigned, the formation of a German coalition government looked shaky as the leader of the Social Democratic Party had to step back from taking on the proposed role of Foreign Minister, and the Brexit debate rumbled on with the UK government apparently making little progress in its negotiations with the EU.

Outlook

Provisional PMIs should point to a slight slowdown in the rate of manufacturing growth

Next week, we get the provisional PMIs for the key economies, with the ZEW survey and IFO Index also published in Germany. We expect these to point to a slight slowdown in the rate of manufacturing activity. In the US, minutes of the January FOMC meeting are released, and Presidents Harker, Dudley and Bostic are all scheduled to speak. We’d be surprised if any of these events led to a material change in the “steer” that the FOMC gives markets on the likely future path of rates. In the UK, the latest batch of labour markets statistics will be released, as will the Q4 2017 GDP numbers. The latter should give a steer on the Brexit impact on investment and, therefore, help shed a little light on the capacity constraint concerns of the central bank. Chinese data are thin on the ground due to New Year celebrations, while in Australia the minutes of the last Reserve Bank of Australia policy meeting and the wage price index for Q4 2017 are released. Given the developments in the labour markets outlined above, we’d be surprised if the annual rate of wage growth increased from the 2% recorded last time round (as would the market).

By Michael Ford, portfolio manager in the Multi-Asset Goup

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