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.
When the Office for National Statistics (ONS) announced wage growth surged to a record-high 7.8% y/y in the three months through June, you might think pay gains finally catching up with the inflation rate would be portrayed by commentators as giving consumers some relief.[i] But that wasn’t the case: Instead, as usual, commentators we follow warned rapid wages would entrench fast inflation, leading businesses to hike prices to recoup higher labour costs and so on in what economists call a wage-price spiral. This, commentators we follow say, means that although inflation has been slowing lately, it won’t last. Some publications we follow pinned UK stocks’ negativity early this week on this apparently grim reality.[ii]
The wage-price spiral is a very, very old theory—and one we think reality has disproved time and again. The US Federal Reserve (Fed), Bank of England (BoE) and many other major monetary policy institutions operate as if it is a foregone conclusion that wages drive inflation. This is why the Fed has a dual mandate of balancing unemployment and inflation—America’s Congress fell for what we think is a myth: that when unemployment is low, workers have more bargaining power to secure wage hikes, which drives inflation, whilst high unemployment reduces wage inflation pressures. Yet time and again, our research shows wages have followed inflation. To anyone familiar with American economist Milton Friedman, this isn’t a surprise. He argued—and showed—in the late 1960s that businesses factor in inflation when adjusting pay to compete for workers.[iii] Putting it another way, they compete on real, inflation-adjusted wages. Not nominal. If this weren’t true, high unemployment would have torpedoed inflation in the 1970s. It didn’t.[iv]
In our view, the aforementioned wage data provide more evidence. What happened a day after that record-setting wage growth hit the wires? Only the news that July’s inflation rate eased from 7.3% y/y to 6.4% when using the ONS’s preferred measure, the consumer price index including owner-occupiers’ housing costs (CPI-H).[v] (The more widely reported figure, headline CPI, also slowed—from 7.9% y/y in June to 6.8% last month.[vi]) This extends a trend of moderating inflation and accelerating wages that began last October, as Exhibit 1 shows.
When is 6.0% annualised quarterly gross domestic product (GDP) growth bad news?[i] Judging from publications we follow, it appears to be when Japan grows solely because exports and government spending masked a sizable drop in consumer spending.[ii] So it went in Q2, with financial commentators we follow dwelling on the big disconnect between external and domestic demand. With Chinese and European consumer demand likely to wobble, the story goes, exports risk petering out, potentially leaving consumption-light Japan with no meaningful growth drivers. We agree it isn’t a great report—far from as good as a 6% annualised rate implies in isolation, in our view. But weak domestic demand isn’t new in Japan, as we will discuss, and we think there are some signs it should turn up soon. Headline growth may slow as the reported post-COVID tourism boom reverts to more normal long-term trends, but Japan will likely continue contributing to global growth, in our view.
Japan’s gap between domestic demand and exports isn’t new—it predates COVID by many, many years and owes largely to entrenched structural issues, according to our research.[iii] Prior governments have passed some reforms to boost competitiveness, but they are taking time to bear fruit, especially with what we consider ill-conceived monetary policy compounding headwinds.[iv] In our opinion, capping long rates at ultra-low levels not only hampers bank lending by reducing loan profitability, but it also keeps teetering companies on artificial life support by keeping debt service costs just low enough to avoid bankruptcy, making it hard for competition to break through. We find this all manifests in weak private investment and slower consumption, which the government tries to cover with public spending and investment.[v] Meanwhile, exporters are able to capitalise on stronger conditions outside Japan and reap tidy profits from currency translation when the yen is weak, making them the country’s primary economic engine.[vi] This helps Japanese multinationals’ stock returns, based on our research, but it doesn’t appear to drive big investment at home.
In our view, Q2 GDP was an extreme example of this long trend. Exports surged 13.6% annualised, rebounding from a Q1 drop.[vii] Public investment jumped 5.0% annualised.[viii] But consumer spending fell -2.2% annualised, business investment barely eked out 0.1%, and imports—which represent domestic demand—dropped -16.2%.[ix] Combine these numbers with another round of disappointing monthly data in China, and we can understand why we saw so much negativity around the report.[x]
UK Q2 gross domestic product (GDP, a government-produced measure of economic output) unexpectedly accelerated, rising 0.2% q/q after Q1’s 0.1%—beating expectations for flattish growth.[i] Throughout financial publications we monitor, many observers acknowledged the long-awaited UK recession (an economic contraction over several months or more) has yet to arrive—and some no longer foreast contraction this year. But we don’t think this is much of a suddenly sunny turn in sentiment—rather, we have seen some economists update their projections to longer-term economic stagnation.[ii] In our view, the sour reaction to mixed, mild growth suggests the Pessimism of Disbelief lingers—a sign to us that economic reality in the UK still has a low bar to clear to deliver positive surprise.
Despite the stronger-than-expected headline growth, the Office for National Statistics’ (ONS) GDP report was a mixed bag. Positively, on a production basis, services grew 0.1% q/q, with 9 of 14 subsectors expanding—notable since the sector comprises the lion’s share of UK GDP.[iii] Consumer-facing services rose 0.8% q/q thanks to food and beverage services, which the ONS attributed to good weather and an increase in live events.[iv] The production sector expanded 0.7% q/q and its manufacturing subset rose 1.6%, with transport equipment adding the most (0.9 percentage point) and the ONS citing growth in automobile production.[v]
Shifting to look at the report on an expenditure basis, strength concentrated in domestic activity. Real (i.e., inflation-adjusted) household consumption grew 0.7% q/q after a flat Q1—which we interpret as a sign of UK consumers’ resilience amidst elevated prices—whilst business investment climbed 3.4% q/q thanks to higher transport investment (specifically in aircraft).[vi]
In our experience, not many things garner the public’s attention like a big round number, and publications we follow sure made hay with one last week: US credit card balances now top $1 trillion (£787 billion) for the first time ever, per a New York Federal Reserve report.[i] In turn, financial commentators we follow raised the alarm about inflation (broadly rising prices across the economy) forcing consumers to accumulate personal debt to keep spending, implying tapped-out consumers will soon pose big economic headwinds. Moreover, we have seen similar chatter around UK consumers’ credit card debt lately, which sits around £66.4 billion.[ii] Not a round, attention-grabbing number, but big enough to raise eyebrows, judging from all the commentary we have read on the matter in recent months. Yet as with all big numbers, we think it is important to scale and consider context. Do so with credit card debt, and we think it becomes clear this isn’t a big economic risk that jeopardises this market recovery.
It can be easy to get hung up on the sheer size of credit card debt, much as people tend to do with UK public debt, in our experience. But as with public debt, we think the total amount outstanding is meaningless. What matters more, in our view, is how big it is relative to society’s ability to keep servicing debt. With credit card debt, we think there are a few ways to look at this. Exhibit 1 shows two: credit card debt as percentages of gross domestic product (GDP, a government-produced measure of economic output) and after-tax personal income. Since credit card debt isn’t adjusted for inflation, we used nominal GDP and nominal income to keep like with like.
As you will see, debt was slightly higher for most of the last 20 years and has fallen markedly from prepandemic levels. Turns out that whilst inflation lifted consumer debt as prices rose, it also boosted incomes and total output.
At Q2’s close, analysts tracked by FactSet expected US earnings and sales to fall, with many presuming this posed a reality check for its stock market in commentary we read.[i] But with nearly all America’s S&P 500 companies reporting, a couple things seem worth noting, in our view: First, just a few sectors are responsible for the S&P 500’s year-over-year earnings decline.[ii] Second, revenues bucked expectations and continued rising overall.[iii] To us, this doesn’t say anything about Q3 or beyond, but we do think it shows reality is better than most anticipated.
With 460 S&P 500 companies reporting through Friday, blended Q2 earnings (combining actual results and remaining estimates) fell -5.0% y/y, whilst blended sales rose 0.7%—both above quarter-end expectations of -7.0% and -0.4%, respectively.[iv] Although a majority of companies typically top earnings estimates, Q2’s 80% beating expectations so far exceeds the 1-, 5- and 10-year averages.[v]
As Exhibit 1 shows, even as earnings declined the last few quarters, sales didn’t, a prominent feature of this cycle, in our view. The three sequential year-over-year earnings drops through Q2 have many commentators we follow calling this stretch an earnings recession.[vi] Some of them also compare this to America’s five-quarter earnings recession that ended in Q2 2016, which—like this one—didn’t come with a broader economic recession (as of yet; a recession is when the economy contracts over a prolonged period).[vii] That earnings downturn then was Energy-driven, too (more on this later).[viii] Though US stocks never entered a bear market (fundamentally driven equity market decline exceeding -20%) then, they did fall somewhat from mid-2015 to early-2016.[ix] Notably, they troughed in February 2016 before earnings did in Q4, anticipating a profit rebound, in our view.[x] We see stocks’ October trough in US dollars this time similarly.[xi]
This has probably been a challenging week to be a bank executive, and not just because credit rater Moody’s downgraded several American banks’ credit ratings on (in our view) old news Tuesday.[i] Late Monday evening, the Italian government announced plans for a windfall profits tax on its banks for 2023.[ii] The news initially hit Italian bank stocks hard as investors seemingly reassessed earnings quickly.[iii] Many commentators we follow suspect this is why Italian officials adjusted the plan the next day, capping the value of lenders’ tax payments to no more than 0.1% of their assets—lower than previous estimates tax payments could hit closer to 0.5% of assets.[iv] As a result, many of the same stocks that fell on Tuesday began climbing back Wednesday.[v] Despite the tax plan being watered down, we think it is worth considering how it might impact the overall economic and market landscape—and whether it adds headwinds materially above and beyond what markets have seemingly already priced in. Spoiler alert: Whilst we don’t think taxes like this are a net benefit, we doubt it materially changes economic fundamentals.
In our view, the plan ostensibly frames European Central Bank (ECB) monetary policy as delivering banks unjustified profits. This hinges on the notion ECB policy drove up loan rates whilst banks haven’t passed the full brunt of short-term rate hikes on to their depositors, similar to the situation in Britain. Hence, net interest income (loan interest revenue minus funding costs) rose. Whatever you think of that, it appears to be the rationale underpinning the move.
Several commentators we follow described the tax as a 40% windfall profits tax, which sounds quite big, but that isn’t quite right. The government will not be taxing all bank profits at 40%. Rather, it will apply this rate to the amount of money politicians think is an undeserved windfall from rising interest rates. The plans define windfall profits as net interest income in excess of 10% growth between 2021 and 2023 or in excess of 5% growth between 2021 and 2022, whichever is bigger.[vi] Not great, in our view, but not as bad as many commentators we follow implied—especially when considering yesterday’s adjustment.
Lately, we have seen soft landing seemingly become the new watchword amongst financial commentators we follow, who claim there is an increasing likelihood the US Federal Reserve has managed to slow growth and inflation without inducing a recession.[i] This attitude runs contrary to recent months, where commentators we follow portrayed any signs of economic growth as presaging more rate hikes and a recession. Yet for all the signals that sentiment is starting to warm, we think there are plenty of indications it remains sceptical overall. One such indication: Contractionary Manufacturing purchasing managers’ indexes (PMIs, monthly surveys that track the breadth of economic activity) received lots of attention in publications we follow on Tuesday, which included warnings of an industrial downturn. Yet, in the publications we track, expansionary Services PMIs received scant notice Thursday. Oddly, the reaction is inverse to services’ and manufacturing’s relative economic importance. Strong services have helped the global economy expand during weak manufacturing stretches before, as we will show, and we think they can do so today—something markets likely see even if people don’t.
In the financial news world, we have observed manufacturing typically receives more attention than services, likely because it is tangible, easier to measure and there is far longer data history of doing so. You just count how many widgets rolled off the assembly line. Most services, by contrast, are tough to measure. A dentist might be able to tally the number of teeth filled, but what of the customer service reps—number of calls taken, hours worked, something else? What about the auto mechanics—how do you equalise engine tune-ups, oil changes, tire rotations and brake system flushes? What about housekeeping, investment advice, teaching, interior decorating and writing MarketMinder Europe articles? All are much harder to tally on a pure output basis that captures the extent and complexity of their economic contributions. Add in the nostalgia from when heavy industry was the world’s economic engine, and we think headlines’ focus on factories is quite understandable.
But services, for all the complexity in measuring it, generates the lion’s share of economic activity. In Organisation for Economic Cooperation and Development (OECD) nations (representing developed and late-stage Emerging Markets), manufacturing is just 13% of gross domestic product (GDP) versus a whopping 70.2% for services.[ii] Whilst it seemingly generates fewer headlines, the latter is much more important to economic growth from a mathematics standpoint.
What a difference 12 days makes! Less than two weeks ago, financial commentators we follow were debating whether the eurozone was in a technical recession, citing sequential quarterly gross domestic product (GDP, a government-produced measure of economic output.) drops in Q4 2022 and Q1 2023.[i] The bloc’s official arbiter—the Centre for Economic Policy Research’s Euro Area Business Cycle Network (EABCN)—hadn’t weighed in and doesn’t even use that criteria, but such technicalities didn’t stop chatter in the publications we read. But then the eurozone’s economic statistics agency, Eurostat, revised Q1’s result from a -0.1% drop to an ever-so-slight advance that rounded to 0% q/q and 0.1% annualised.[ii] Then, on Monday, Q2’s preliminary GDP report said output grew 0.3% q/q (1.1% annualised), hitting a new high to boot.[iii] Yet, despite this undercutting the eurozone is in recession narrative from two points of view, commentators we follow don’t seem to have brightened their economic outlooks. Several still warned of stiff headwinds in Germany, weak growth and stubborn inflation (broadly rising prices across the economy). In our view, this is good news: It suggests sentiment still hasn’t caught up to reality, leaving more of the proverbial wall of worry for eurozone stocks to climb.
In our view, pedestrian is probably the best word to sum up the eurozone’s combined Q2 growth. We think it is fair to say 0.3% q/q isn’t much to shout about, and it lags US growth.[iv] Yet our research suggests stocks don’t hinge on absolute results—it is much more about how results compare to investors’ expectations, in our view. From that standpoint, to the extent that combined eurozone GDP figures even mean much, we think results this year to date are pretty darned good. This time last year, most forecasts we saw projected the eurozone would suffer a recession as energy shortages and spiking prices hammered businesses and households alike.[v] The European Commission’s November 2022 forecasts, probably the most optimistic of the bunch, projected “the euro area and most Member States [falling] into recession in the last quarter of [2022].”[vi] It anticipated a recovery beginning this year, but only enough to deliver full-year growth of 0.3%.[vii] That happens to be the bloc’s year-to-date growth at the halfway point.[viii]
With loan growth slowing below the inflation rate—signalling contractionary monetary conditions in real (inflation-adjusted) terms—the economy could yet slip as the year rolls on.[ix] But we think that has also been the case for several months and for now, at least, things are clearly going better than expected. Not only at the regional level, but at the national level, too. Also contrary to the Commission’s forecasts, 13 of the current 20 euro members grew in Q4 2022 and a slightly different cast of 13 grew in Q1.[x] Of the 10 reporting for Q2 thus far, only Italy, Latvia and Austria contracted.[xi] So forecasts of widespread national recessions didn’t come true. We think this has a lot to do with eurozone stocks soaring 30.5% in pounds since their low last October 2022.[xii] In our view, this makes global stocks’ 12.2% return over the same period look less impressive.[xiii] It didn’t take an economic miracle. A slow regional plod sufficed.
US Q2 gross domestic product (GDP) accelerated in last Thursday’s report, smashing forecasts and triggering a rush to revise outlooks amongst onlookers we follow.[i] We now see many suggesting a soft landing of slower growth that avoids recession (prolonged economic contraction) is likely. Others we read argue no landing is coming at all. And we have seen some others claim relatively rapid growth will spur more Federal Reserve (Fed) rate hikes, causing recession anyway. In our view, all this chatter misses the mark. Q2 GDP shows America wasn’t in recession last quarter, barring a big revision.[ii] And we think it speaks to the better-than-anticipated economy stocks have long been pre-pricing. But to us, the forward implications beyond that are very limited. Let us explain.
Exhibit 1 shows America’s Q2 GDP (dark blue line) sprang higher at a 2.4% annualised rate, much faster than consensus estimates for 1.5%.[iii] Whilst consumer spending (dark green columns) continued to chug along, business investment’s (medium green) 7.7% annualised surge stood out to us. Then, too, we find the GDP components that detracted substantially in recent quarters mostly aren’t anymore. After residential investment (light green) subtracted significantly in Q2 through Q4 last year, it did so only marginally in Q1—and again in Q2.[iv] Meanwhile, inventory changes’ (maroon) big Q1 detraction—which many commentators we follow also portrayed as a recessionary sign—turned into a small contribution in Q2.[v] With consumer spending and business investment up solidly—plus housing headwinds and inventories’ drag fading—we think it is tough to argue America was in or even all that close to recession in Q2. Hence, we see many economists rushing to update their views.
Exhibit 1: US GDP and Its Contributing Components
Source: FactSet, as of 27/7/2023. US real (inflation-adjusted) GDP and components, Q1 2022 – Q2 2023.
Is the UK slipping into a debt crisis of its own making? Commentators we follow have begun asking this question in the wake of a new report showing the UK has more debt with inflation-linked interest payments than any other major country.[i] With floating-rate debt constituting nearly 25% of overall outstanding Gilts, it is more in line with many Emerging Markets than developed, according to recent research.[ii] The relatively high share wasn’t historically a problem, but recent hot inflation (economy-wide price increases) has ratcheted up interest payments, leading many commentators we follow to argue public finances could be in trouble. And it is true, payments have jumped.[iii] But we see some mitigating factors we think are widely ignored, suggesting to us there is a high likelihood these warnings won’t come to fruition, which likely helps UK stocks keep climbing.
In a vacuum, we can see why the raw numbers don’t look great to many observers. Exhibit 1 shows UK central government interest payments on a rolling 12-month basis, with conventional and inflation-linked (aka index-linked) Gilt interest payments separated. Total interest payments have more than doubled since 2020, and index-linked Gilts are responsible for the vast majority of this.
Exhibit 1: Central Government Interest Payments (Trailing 12-Month Basis)
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.
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