Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.
As global markets suffered another bad day Monday, investors had more dreary news to chew over. One bit came from the UK, where the Office for National Statistics (ONS) reported monthly GDP fell -0.3% m/m in April, the second-straight drop—setting off another round of UK recession chatter.[i] In our view, the jury is still out on the UK economy and whether this year’s painful cost-of-living increases will be enough to tip consumer spending—and overall output—negative for a sustained period. But under the hood, the seemingly weak GDP report actually featured some reasons for optimism.
As most of the coverage rightly pointed out, all three of the major monthly GDP components—services, heavy industry and construction—fell. Industrial output fell -0.6% m/m, with manufacturing (-1.0%) leading the way down, while construction activity fell -0.4%.[ii] Services—about 80% of total UK output—fell -0.3%, but this comes with a big asterisk: the end of COVID testing and tracing and the vaccination drive.[iii] COVID-related activity has skewed GDP wildly at times over the past two years, as it shows up as big jumps and dives in the human health and social work activities component of services industry output—an economic accounting quirk that is largely unique to the UK. This category fell -5.6% m/m in April, shaving half a percentage point off the service sector’s growth rate.[iv] Exclude it, and services would have grown 0.2% m/m, which would be enough of a move to make headline GDP growth flattish or slightly positive. Now, flattish growth isn’t great, but it also isn’t a deepening contraction, and the latter is what everyone fears now.
Elsewhere in the services sector, there were some bright spots—especially in consumer-facing areas that, in theory, should be benefiting from the easing of COVID restrictions and return of travel and leisure activities. Overall, the ONS estimates consumer-facing services rose 2.6% m/m.[v] Wholesale and retail trade jumped 2.7% m/m—and that figure is adjusted for inflation—while activity at restaurants and hotels rose 1.0%.[vi] The nebulously named “other service activities,” which includes the beauty industry, soared 5.5% m/m.[vii] Interestingly, retail’s rapid rise came despite the tax hikes and energy price cap increase that took effect in April, suggesting that—at least at the outset—consumers were far more resilient to these added pressures than economists anticipated. Also positive: Auto sales contributed strongly to the retail total as supply recovered, confirming our hunch that March’s slide wasn’t a product of weak demand.
Ouch. Today’s CPI report showed US inflation reaccelerating to 8.6% y/y in May—notching a new 40-year high—and stocks didn’t like it.[i] The S&P 500 dropped -2.9% in price terms on the day, extending Europe’s earlier declines.[ii] Fast inflation and market volatility is a painful combination, especially for those trying to grow their assets over time to support living expenses. The fear of hardship is real, and we get it. So at times like this, we think it is best to breathe deep, think longer term and remember some first principles.
The precise reasons for sharp volatility are always impossible to pin down. On its face, the CPI acceleration was modest, and the 8.6% rate is but a whisker faster than March’s 8.5%. But it wouldn’t surprise us if the world’s expectations heading into today were a touch too optimistic. You see, for the past two months, the financial world’s general take on US inflation is that it is peaking. We saw it when the inflation rate hit its prior high in March—there was a lot of this is the top chatter. We saw it in April, when CPI decelerated to 8.3% y/y—then, it is finally easing was the general spirit. On both occasions, we counseled against that mentality and the follies of trying to predict such turning points in general.
Today’s market reaction is a prime example. Last month, as the world cheered April’s CPI slowdown, we cautioned:
Last Friday the Bureau of Labor Statistics released May’s jobs report, which revealed nonfarm payrolls rose 390,000, exceeding estimates of 322,000, while the 3.6% unemployment rate was a tick higher than expectations for 3.5%.[i] Oddly, some pundits fretted the data were too strong, arguing the Fed must act to cool the economy and hot labor market, which they posit could further fan already hot inflation. Ergo, with an eye toward next week’s Fed meeting, ongoing quick jobs growth may mean more rate hikes are coming—risking a sharper-than-desired economic slowdown. However, this argument overstates the link between jobs and monetary policy—and the Fed’s powers, in our view.
Since the Fed’s dual mandate targets maximum employment while ensuring price stability over time, one might think it stands to reason there is a link between unemployment and inflation—and that the Fed will use its tools to raise or lower unemployment as needed to maintain price stability. Fed officials’ public comments seem to imply as much. Fed Chair Jerome Powell said recently that an unemployment rate consistent with stable inflation “is probably well above 3.6%” these days while Fed Governor Christopher Waller spoke last week about curtailing excess job openings to help cool prices.[ii]
But changes in interest rates don’t directly affect hiring. For one, businesses generally don’t borrow to fund payroll. Borrowed capital typically goes to longer-term investments in facilities, capital equipment and intellectual property. That may mean some hiring further downstream, but the impact isn’t direct and it certainly isn’t quick.
A curious trend has emerged in European economic data in recent weeks—one we think is worth watching. While so-called soft data (e.g., survey-based indicators, chief among them purchasing managers’ indexes, or PMIs) have stayed strong across the board, some hard data (e.g., output measures like retail sales and industrial production) have struggled. French industrial production and German retail sales defied PMIs with contractions in recent days, missing consensus expectations in the process. German industrial production, released overnight, did grow 0.7% m/m in April, but that figure missed expectations—and follows a worse-than-expected -3.7% decline in March.[i] Now, we don’t think this is predictive for eurozone stocks, as markets are forward-looking. But we do think the data perhaps shed light on what eurozone stocks have priced in already, and they illustrate the follies of relying too much on any one indicator.
Exhibits 1 – 4 show the past few months’ worth of hard and soft data for the eurozone’s four largest economies (Germany, France, Spain and Italy). We limited our look to this short window for a simple reason: Pundits globally warn the war in Ukraine is a huge risk for Continental Europe’s economy, and that conflict started in late February. One looking only at PMIs would presume all four have sailed through with flying colors. But harder data show some struggles.
Exhibit 1: Germany
Lately—and predictably—we have seen a fair amount of handwringing about the dollar. It seems like just yesterday people were worried it was too weak. Yet now it is supposedly too strong, threatening US multinationals’ earnings. Some companies have already started blaming it for worse-than-expected results. Now, in our experience, the dollar rivals the weather as possibly companies’ favorite scapegoat when lowering guidance for future earnings, and it wouldn’t surprise us if some were merely reverting to old blame habits. For a strong dollar isn’t inherently good or bad—it just is.
Conventional wisdom says a strong dollar is bad for big exporters because it can hit revenues. When the dollar is strong, if a company wants to charge the same amount in dollars for a given product sold abroad, it has to raise prices in the receiving country’s currency. That can limit demand. Or, to preserve demand, the company can hold prices in the end market’s currency constant, reducing the amount they get in dollars. Sales volumes may hold up better, but revenues fall, and profit margins take a hit.
That is the theory, and mathematically it is true. But it ignores a key mitigating factor: Few companies source all components and manufacture final goods in their home country. The vast majority of firms import parts, raw materials and even labor. A strong dollar makes all of these imported costs cheaper. It may not be a perfect offset for the hit revenues can take under these conditions, but it does cancel a good deal of the effect and help preserve margins. It may even benefit some firms more than the strong dollar hurts sales. But also, beyond this, most companies also hedge for currency swings, limiting the impact of sharp moves. Note that with most companies reporting, S&P 500 gross operating profit margins (revenue minus cost of goods sold, divided by revenue) held pretty darned firm in Q1, slipping less than a quarter of a percentage point from Q2.[i]
Editors’ note: MarketMinder is nonpartisan, neither for nor against any party, politician or policy. Though inflation has become a politically charged topic, our analysis focuses only on its—and surrounding developments’—potential impact on the economy and markets.
If rising prices are hurting so many, why not just outlaw them? It sounds so simple. But, in practice, history has proven such price controls to be highly problematic in practice. Prolonged price pressures have raised calls for government action and led to some actual legislation—e.g., windfall profits taxes in Europe. In the US, there are efforts to go further, with prospective price control bills in Congress barring “gouging.” While passage doesn’t seem likely, we wouldn’t rule it out. We are watching their progress because, if adopted broadly, we think they could pose headwinds for the economy and markets.
Why are price controls such a bad idea? They distort price signals, which are core to markets’ functioning effectively and, not unrelatedly, economic growth. Prices balance supply and demand, coordinating production and consumption. They are signals, full stop. On the demand side, when they are high and rising, they encourage more people to cut back, substitute and economize. At the same time, high and rising prices imply greater potential profit, signaling producers to boost supply—which eventually helps keep prices in check.
Summer Mondays are always a bit hard. You know the feeling—the kiddos are home for the summer enjoying lazy sunny days. The weather is warm and enticing. Vacation season is nearing full swing. Everything seems to move a bit slower. But not so this year: Global politics’ start to the season seems far busier than the norm, giving us plenty of market-related tidbits to consider. As always, we don’t prefer any politician or party in any country, and we look at these developments through a purely market-oriented lens. So what are the potential market implications of the Conservative Party’s move against UK Prime Minister (PM) Boris Johnson, the latest handwringing over this month’s French legislative elections and a potential Swedish government collapse? Let us explain.
Boris Johnson Keeps His Job … for Now
When last we left Johnson—last Thursday, to be specific—the PM was refusing renewed calls to resign over the latest revelations in the “Partygate” scandal. But that was before he got booed entering the service of thanksgiving for Queen Elizabeth II at St. Paul’s Cathedral on Friday, part of the Platinum Jubilee celebration. And before a memo arguing he was a surefire election loser went viral among Conservative members of Parliament (MPs) over the weekend. And before enough MPs submitted no-confidence letters to the party’s 1922 Committee, triggering a no-confidence vote Monday.
As Britain gears up for Queen Elizabeth II’s Platinum Jubilee—celebrating 70 years on the throne—the Commonwealth she heads is having quite a busy week. In Canada, the central bank made another 50 basis-point rate hike while fanning inflation fears. In Australia, a solid Q1 GDP report did little to quiet the lucky country’s own inflation fears. And in the UK, the scandal known as Partygate flared up again, renewing calls for Prime Minister Boris Johnson to step down. What does it all mean for stocks? Read on!
Canada Takes a Hike
The Bank of Canada (BoC) hiked its benchmark rate by half a percentage point for the second straight time on Wednesday, bringing the rate to 1.50%—the highest among major developed nations. While the widely expected move didn’t ruffle many feathers, the press release raised eyebrows for saying the BoC is ready to “act more forcefully” if needed to tamp down inflation—a seeming change from April, when BoC head Tiff Macklem dismissed talk of a 75 basis-point move.[i] It went on to note that policymakers don’t think inflation has peaked, arguing inflation rates “will likely move even higher in the near term before beginning to ease.” Not only is the change in tone stirring uncertainty about more severe rate hikes from here, but it is further fanning inflation fears.
Global energy markets got a big dose of seemingly bad news on Monday and Tuesday, with the EU announcing sweeping sanctions on Russian oil and Russia cutting off natural gas shipments to the Netherlands and some suppliers in Denmark and Germany. And in response, oil and natural gas markets … didn’t freak out. Brent crude oil prices and Dutch TTF natural gas prices (the European benchmark) inched higher but remain below their recent peaks, which they set shortly after Russian troops invaded Ukraine and the US and UK unveiled their bans on Russian energy. Notwithstanding the potential for further volatility from here, the relatively muted reaction doesn’t totally shock us. As we will discuss, while the latest developments aren’t great from an economic standpoint, they don’t appear likely to result in outcomes worse than the widespread fears markets have already priced in. Moreover, both moves should help put an end to questions over what will happen, which likely reduces uncertainty and helps markets move on.
The EU’s measures, announced Monday, were both worse and milder than many feared. Milder because while the EU announced it will ban all seaborne imports of Russian crude oil, the sanctions exempted shipments via pipeline in order to avoid handicapping landlocked nations, like Hungary, that don’t have the infrastructure to replace Russian crude. That gives the most Russia-reliant nations—and the bloc overall—some needed flexibility. But the measures are also heavier than expected, as they will ban all EU insurers from covering seaborne shipments of Russian oil—a provision that wasn’t a part of the initial public debate. Given European insurance companies presently insure the vast majority of tankers carrying Russian oil, this restriction aims to prevent Russia from continuing to sell discounted crude to China, India and other Asian nations. As many observers note, this is likely the more important of the measures. If it worked exactly as intended and stranded Russia’s oil, it would probably have a material impact on global oil supply.
But that is sort of a big if. For one, these actions don’t take effect immediately, giving room for the global oil trade to readjust. The insurance ban doesn’t come into force for six months. Two, it is unclear to us that banning EU insurers from covering tankers ferrying Russian crude will really stop up the drain. European insurers may cover the majority of shipments for now, but they aren’t the only game in town. Insurers from nations that aren’t participating in sanctions, including India and China, could fill the void. Some observers suggest the Russian government could write its own insurance.[i] Then too, Russia could simply ship more oil and gas to these nations via pipelines and rail, as these links are already established (and the former are expanding).[ii] Heck, black and gray markets could even flourish. Maybe Russian crude makes its way to refiners and ports in other nations and takes to the sea in disguise. It isn’t even clear Russian oil products are sanctioned, providing the refining or blending takes place in a third-party country like India.
Investors got a fresh dose of Chinese economic data overnight Monday, this time with the official May Purchasing Managers’ Indexes (PMIs) signaling continued contraction in May. The rate of decline eased significantly from April, but it still doesn’t point to growth. That is the bad news. The good? Shanghai is lifting its lockdown, and life there will start returning to a semblance of normal on Wednesday. Beijing also reportedly eased some curbs over the weekend. Local officials have also announced a raft of measures to help support a rebound. Now, we don’t think any of this points to a rapid acceleration in Chinese GDP growth—but we also doubt that is necessary for Chinese or global stocks at this point. Rather, the combination of reopening and targeted fiscal and monetary assistance should help reality turn out better than widespread fears of a deeper malaise—a positive surprise.
PMIs are what those who love economic jargon call “soft data.” They don’t report growth rates. Rather, they are surveys measuring the percentage of businesses reporting increased activity in a given month. Readings over 50 indicate expansion and under 50 contraction—with growth and/or contraction theoretically getting faster the further readings get from 50. So from that technical standpoint, May’s PMIs showed some signs of stabilization. The official manufacturing PMI rose from 47.4 in April to 49.6—still shrinking, but barely.[i] The sub-index for large manufacturers even rose to 51.0, returning to growth.[ii] The non-manufacturing PMI, which includes the increasingly important services sector, jumped from April’s 41.9 to 47.8, with most of the increase coming from forward-looking new business.[iii] Note that these signs of stabilization arrived despite some main economic hubs reportedly remaining under strict COVID restrictions, which we think points to some underappreciated resilience.
It also sets the baseline for what comes next, as those restrictions are starting to end in Shanghai. Starting on Wednesday, people in “low-risk” areas of the city can leave their house for more than a few hours at a time. They can return to work. They can use public transit. Those who have slept at work due to the severe restrictions on movement can finally return home. Indoor dining will remain banned, but shops will be able to operate at 75% capacity. Now, this isn’t a full return-to-normal, as frequent mandatory testing persists and there is no indication that the federal government has abandoned its zero-COVID aims. A resurgence in cases could bring some restrictions back. But for now, relaxation should help enable a recovery.