MarketMinder Europe 

MarketMinder Europe

MarketMinder Europe provides our perspective on current issues in financial markets, investing and economics. Our goal is to analyse key topics in an entertaining and easy to understand manner, helping you see the news of the day in a unique perspective.

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

An Economic Data Check-In

Lately, we have seen economic data coming out a bit better than expected. Whilst a backward-looking glance won’t dictate where markets are headed, we think it helps lay down the baseline reality from which to gauge sentiment. Have a look at some of the higher-profile recent reports.

America’s July personal consumption expenditures (PCE) release last Friday showed inflation-adjusted consumption rising at Q3’s start and inflation (economy-wide price increases) moderating. Real PCE—aka consumer spending—rose 0.2% m/m.[i] (Exhibit 1) In our estimation, that isn’t gangbusters, but it is right on its monthly average rate since 2002.[ii] To us, that indicates underlying demand is holding up despite inflation.

Exhibit 1: American Consumer Spending Growth Slow, but Still Upward

Source: US Federal Reserve Bank of St. Louis, as of 1/9/2022. US real PCE and its goods and services components, January 2002 – July 2022. Recession shading uses US National Bureau of Economic Research (NBER) business cycle dates. NBER defines recession as a significant decline in economic activity that is spread across the economy and that lasts more than a few months.

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Will a ‘Housing Recession’ Spur Wider Economic Contraction?

With commentators we follow warning a UK property downturn looms, we think a look across the pond—where similar concerns have sprouted—may be instructive for investors. Last week, America’s National Association of Home Builders’ August survey suggested its members’ sales conditions are starting to deteriorate as US mortgage rates have doubled from last year, leading it to declare a “housing recession” is underway.[i] Besides ongoing supply chain problems lifting construction costs, builders noted cancellations are spiking. With American home inventories rising, housing starts slowing and reports of sellers slashing prices to attract baulking buyers, headline chatter over a potential residential real estate collapse is growing. Many of them warn such a downturn could hit the US economy hard—and send stocks slumping anew. But although the housing market may be weakening, we don’t think stocks are likely to mind much.

The American housing market has indeed hit a rough patch. US home sales have dropped sharply.

Exhibit 1: America’s Home Sales Sinking

Source: FactSet, as of 26/8/2022. US Census Bureau new privately owned houses sold and National Association of Realtors existing homes sold, January 2000 – July 2022.

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The UK's Commodity Supply Chain Adapts

Seemingly every couple weeks, we see more news breaking that yet another global energy producer is ramping up oil and natural gas exports to Europe. Israel is the latest example, with its energy ministry announcing natural gas production is up bigtime year to date amidst plans to increase exports to the EU.[i] We have seen many such anecdotes involving non-Russian suppliers, including Azerbaijan, Qatar, the US and others, but data on how all of this is panning out has been a bit thin, in our view.[ii] Germany publishes monthly crude oil imports by country but not natural gas. The Netherlands publishes both, but the data are values (in euros), not volumes (in barrels or tonnes or the like), subjecting them to big skew from commodity price swings. So you can imagine our excitement on Wednesday, when the UK’s Office for National Statistics (ONS) posted a report detailing how the country has adapted to Russian sanctions. It is but one example, but we think knowing how the UK has replaced Russian commodity imports may help investors get a better sense of how supply chains are readjusting, perhaps easing uncertainty as we head into the winter.

The UK’s main commodity sanctions included a pledge to phase out all Russian crude oil imports by yearend, cease natural gas imports as soon after that as possible, and ban all iron and steel products.[iii] As the ONS notes, Russia accounted for 24.1% of the UK’s refined oil imports in 2021, 5.9% of its crude oil imports and 4.9% of its natural gas imports.[iv] Now, the UK also produces its own crude oil, refined petroleum and natural gas, so these percentages don’t represent Russia’s share of UK consumption, which was more like 8% of total oil and oil products, according to Business Secretary Kwasi Kwarteng’s March estimates.[v] Much of its natural gas imports are also re-exported to Continental Europe.[vi] But refined petroleum imports in particular play a key role in the UK, making Russia’s impending absence an important hole to fill.[vii] Unsurprisingly, UK businesses haven’t waited for the bans to take effect: Russian fuel imports fell to zero in June.[viii] Meanwhile, the UK imported more refined oil from the UAE, Saudi Arabia, Belgium, the Netherlands and India.[ix]

That last one is perhaps most of interest, in our view, given India hasn’t ceased buying Russian crude—actually, it has ramped up Russian imports bigtime and is reportedly refining Russian oil into petrol and diesel shipped globally.[x] We think it is entirely possible that the UK is now simply buying Russian crude that was refined in India, underscoring an important point about energy markets, in our view: They are fully global, and total global production is what ultimately matters most. Even if Russian petroleum products are taking a more circuitous route than usual, they are still contributing to global supply, which we think goes a long way toward explaining oil prices’ fall from their March peak.[xi]

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What to Consider in August’s Purchasing Managers’ Indexes

Has a global recession—a period of contracting economic output—begun? Financial commentators we follow asked that question Tuesday after S&P Global’s flash US Purchasing Managers’ Indexes (PMIs) for August showed declining output in most major economies.[i] In our view, that makes today ripe for a timely reminder: Regardless of what the global economy is doing this month, we think stocks generally look about 3 – 30 months out and have likely already digested whatever business surveys and output metrics will eventually confirm happened.

PMIs, unlike so-called hard data like retail sales and industrial production, aim to use survey responses to determine the economy’s general direction. They ask participants how business evolved across a range of categories including output, new business, employment, inventories, supplier deliveries, prices and others, then mash the responses into a number. Readings over 50 generally indicate expansion, with growth broader the farther above 50 it is. Similarly, under 50 normally means contraction, with lower readings implying widespread declines.

Exhibit 1 shows the flash results for August, which S&P says include about 85% of expected responses.[ii] The Manufacturing and Services columns show headline indexes—the aforementioned mashups. The Composite column aggregates Manufacturing and Services output only, hence its apparent divergence.

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On Europe and the UK's Energy Pain

Europe’s energy crisis has dominated headlines of financial publications we follow for nearly a year, with many arguing shortages will lead to recession (a broad decline in economic activity). The Continent’s hot and dry summer has further stoked energy supply concerns, as droughts impact increasingly in-demand electricity. We don’t dismiss the economic pain for households and businesses, but our focus is on the market impact. In our view, the widespread discussion of an energy-driven recession across Europe reveals how weak sentiment is—a sign of the low bar reality must clear to positively surprise, in our view.

It is easy to see why sentiment has sunk so far, in our opinion. Natural gas prices are surging in Europe, with hot weather boosting demand and Russia throttling supply in response to EU sanctions.[i] Russian gas flows through the Nord Stream 1 pipeline have been around 20% of contracted volumes since late July, straining Europe’s ability to generate power whilst filling storage for the winter.[ii] There have been repeat warnings amongst financial publications we follow that even this flow will cease fully, particularly during periods when Russia claims to be performing maintenance, including today’s announcement in which Russia’s state energy giant imposed a three-day shutdown order on the Nord Stream 1 pipeline for gas compressor repairs.[iii] Beyond this, the summer heat has impacted other energy sources: In France, high river water temperatures are interfering with nuclear reactor cooling. In the UK, energy regulator Ofgem will announce October’s energy price cap (which resets semiannually) on 26 August, and we have read some observers estimate the new cap will double today’s record levels—worsening UK households’ burden.[iv]

Politicians have responded in myriad ways, based on our review of the latest reports. The EU has asked member states to reduce gas demand voluntarily. Some governments have imposed new taxes, from the UK’s windfall tax on energy firms, which passed last month, to Germany’s levy on households to help utilities. Elected officials have also sought to provide relief. Italy approved a €17 billion aid package whilst the Netherlands cut energy taxes for 8 million households.[v] The contenders in the UK Conservative Party leadership contest are each reportedly preparing household assistance packages to introduce once they take office next month.[vi] France plans to re-nationalise power operator EDF—in which it already owns an 84% stake—in order to sell electricity below cost without getting pushback from minority shareholders.[vii] An example of that resistance: The government ordered EDF to sell nuclear power to its rivals at below-market prices, and EDF is now suing for having to take a loss.[viii]

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Britain's Sky-High Inflation Fosters Gloomy Forecasts

The UK notched a dubious milestone in July, becoming the first major country to record double-digit inflation (broadly rising prices across the economy) this year. The Consumer Price Index’s 10.1% y/y rate is the fastest since 1982, and the Office for National Statistics (ONS) estimates it is just the fourth trip over 10% in 70 years.[i] This is obviously not good news, not least because essential goods and services—food, petrol, household energy—fuelled much of the rise.[ii] But even excluding food and energy, core inflation accelerated to 6.2% y/y, driving commentators we follow to warn entrenched price hikes will hit consumer spending hard—and likely give UK stocks a nasty recession to price in.[iii] In our view, a UK recession is possible and could already be underway. But we see reasons to think reality has a higher likelihood of going better than analysts we follow foresee, not worse.

With that said, we think inflation is quite likely to accelerate from here due to the forthcoming rise in the default household energy tariff, which energy regulator Ofgem is due to announce next week and will take effect in October. Some researchers anticipate it will double the current ceiling in order to reduce the risk of more suppliers going bust if power is in short supply this winter. The Bank of England (BoE) projects the cap increase will cause inflation to pass 13% y/y in October—a forecast some commentators we follow warn is too optimistic.[iv] Labour market data released earlier this week showed real (meaning, inflation-adjusted) wages falling at the fastest rate in the dataset’s short history over the three months ending in June (-3.0% y/y), a figure that doesn’t account for either the forthcoming price cap hike or the fact that income tax bands currently aren’t indexed to inflation.[v] So we can understand why observers suggest the consumer spending outlook is bleak.

Yet there is some history of consumer spending growing despite falling real wages. Inflation-adjusted wages fell on a year-over-year basis in every month from November 2009 through September 2014—a long, dismal stretch of seemingly falling living standards. The peak-to-trough drop, using the seasonally adjusted monthly inflection points of April 2009 and June 2014, was a painful -6.0%.[vi] Yet from the end of Q1 2009 through Q2 2014, inflation-adjusted quarterly consumer spending rose 9.1%.[vii] There were some occasional quarterly contractions, but the UK didn’t slide into recession during this stretch. Lest you think spending rose only because people borrowed beyond their means, consumer credit actually fell by over £25 billion over this span.[viii] The much-discussed consumer borrowing boom came later, in the decade’s second half, by which time real wages were rising.[ix] We aren’t saying that period is a perfect analogue for now, but we think it shows falling real wages aren’t assured to sink spending.

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America’s Q2 Earnings in Focus

America’s Q2 earnings season is winding down, with the vast majority of S&P 500 companies having reported.[i] Given the US is 70% of developed world stock market capitalisation, we think its profit picture is worth reviewing for global investors.[ii] The results? Three-fourths of those reporting so far beat expectations, and revenues did much of the heavy lifting.[iii] Yet whilst Energy earnings soared, profits in the other 10 sectors combined fell, echoing the split amongst sector returns during this year’s stock market downturn.[iv] In our view, this is a good reminder that stocks look forward.

In US dollars, US and global stocks’ declines this year breached -20%, which is the traditional threshold for a bear market—an extended deep stock market decline, typically with a fundamental cause.[v] As Exhibit 1 shows, S&P 500 sector returns in US dollars from their early peak this year through the year’s low point to date on 16 June mostly seemed to preview how earnings turned out. Whilst S&P 500 earnings overall rose 6.7% y/y, much of that came from Energy earnings soaring 299.2%.[vi] Excluding Energy, they fell -3.7%.[vii] So whilst headline earnings growth was near its 7.1% annualised average historically, we think it masks some underlying weakness.[viii] Yet first-half sector returns appear to us to have largely captured the earnings dynamic below the surface, with only Energy positive through Q2.[ix] Markets anticipated high oil prices’ impact on Energy earnings well in advance of official reports, in our view.

Exhibit 1: S&P 500 Sector Returns, 3/1/2022 – 16/6/2022

Source: FactSet, as of 16/8/2022. S&P 500 sector total returns in US dollars, 3/1/2022 – 16/6/2022. Currency fluctuations between the US dollar and pound may result in higher or lower investment returns.

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The Puzzle in UK GDP

UK gross domestic product (GDP, a government-produced measure of economic output) came out Friday morning, and here are the facts: Output fell -0.1% q/q in Q2, according to the Office for National Statistics’ (ONS) first estimate, with the bulk of the decline seemingly coming from June’s -0.6% m/m drop.[i] In our experience, the logical interpretation would be that the flattish quarterly reading obscures a late-quarter slide, implying the economy has weakened significantly since spring and signalling bad times ahead. However, due to some calendar quirks that the ONS warned skewed monthly data pretty heavily, in this case we think the quarterly figure is probably more telling.[ii] We don’t think it is predictive, and in our view, stocks are likely looking ahead to the next 3 – 30 months rather than what happened in April through June. But we think putting these data in context can help investors better weigh economic fundamentals overall.

The calendar quirk in question is the Queen’s Platinum Jubilee, which pulled one bank holiday from May into June and added another to the calendar.[iii] This resulted in two fewer working days in June and an extra one in May, which the ONS warns threw off their seasonal adjustments. The official monthly GDP release states plainly that there will be a visible effect on both May and June data and concludes: “Caution should be taken when interpreting the seasonally adjusted movements involving May and June 2022.”[iv]

In our view, this should provide some relief about the fact that all major categories—services, heavy industry and construction—declined month-over-month.[v] We think most of that drop stems from having fewer working days in June than May. Similarly, the jump in entertainment services and restaurant spending probably stems from people having two additional days of leisure—days with big celebrations up and down the country to celebrate the Queen’s 70 years on the throne. We don’t view this boom as any more representative of the country’s underlying economic health than the drops in other categories of services and the manufacturing industry. We aren’t saying there is no core weakness. Businesses reported higher energy and input prices as headwinds in June, which may have contributed to falling output in the categories that rely on petrochemical feedstock.[vi] But with so much one-time skew, it is impossible to disentangle the two, in our view. We think July data could benefit from an easy comparison to June, so we probably won’t get a clearer read until August figures hit the wires—which won’t happen until mid-October.

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An Overlooked Reason Behind July’s Slowing US Inflation

Editors’ Note: Inflation remains a hot political topic, so please understand that our commentary is intentionally non-partisan and focused on the potential market implications only.

America’s July inflation report made headlines globally this week, with good reason: The US generates about one-fourth of global economic output and represents about two-thirds of the developed-world stock market, making developments in America key worldwide.[i] So when the report revealed that the inflation rate decelerated from June’s 9.1% y/y to 8.5% y/y, we noted much relief amongst financial commentators we follow.[ii] We also saw ample discussion of the deceleration’s causes, with much attention centering on falling petrol and jet fuel prices. Whilst those played a role, we see an additional, widely overlooked explanation, and we think understanding it can help investors set realistic expectations for a big chunk of the global stock market over the period ahead.

That explanation: a mathematical phenomenon called the base effect. The inflation rate, as a year-over-year calculation, measures the percentage change between prices in one month and that same month a year prior. The base is that year-ago price level, which is the denominator in the calculation. As we all learnt in primary school fraction lessons, a higher denominator can result in a smaller quotient—and vice versa. That is what happened in July.

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On the BoE’s Dreary Forecast

The Bank of England (BoE) announced its biggest interest rate hike since 1995 last Thursday, raising the Bank Rate from 1.25% to 1.75%—but that wasn’t the day’s biggest news, based on our reading of financial commentary.[i] Paired with that rate hike was the BoE’s August Monetary Policy Report, which included the bank’s updated economic forecast. That forecast: Consumer Price Index (CPI) inflation reaching 13% y/y when the household energy price cap resets higher in October and a recession (a period of contracting economic output) starting that quarter and lasting all of 2023.[ii] (CPI is a government-produced measure of goods and services prices across the broad economy.) Looming over all of this is a fierce political debate on the BoE’s mandate and independence, which has featured in this summer’s Conservative Party leadership contest.[iii] We see some potential medium-term risks for UK stocks here, but not the ones that might seem most intuitive. Let us discuss.

When last we left the BoE in May, its top-line forecast was for inflation at 11% y/y and a -0.25% gross domestic product (GDP, a government-produced measure of economic output) contraction in 2023.[iv] Now it says the most probable scenario is CPI hitting 13% this autumn and GDP falling -1.25% in 2023.[v] Our May coverage discussed the BoE’s methodology and inputs at length, so we won’t rehash that here, but suffice it to say they mostly extrapolate recent conditions forward, which we think is a big reason why forecasts often don’t pan out. (Which, in turn, appears to be part of the reason for the political kerfuffle over the BoE’s status, which we will turn to momentarily.)

The BoE could prove correct. Wage growth, whilst strong in nominal terms, has lagged inflation, and in our view, the patchwork quilt of tax credits and rebates hasn’t offset the headwinds of this spring’s tax hikes and spiking household energy costs.[vi] We can envisage a potential scenario where GDP grows steadily in nominal terms (meaning, not adjusted for inflation) but shows as contraction once the inflation adjustment kicks in. That would represent a fall in living standards and, yes, recession by most definitions. Plus, the yield curve, which is a graphical representation of a single bond issuer’s interest rates across the spectrum of maturities, spent the past two weeks ever-so-slightly inverted, and as we write, it is just barely positive.[vii] Couple that with slight falls in broad lending and money supply in June, and we see some indication conditions are tightening.[viii]

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Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.

Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom. Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission.