As at 7 June 2023
Author: Gavyn Davies, Chairman
- Markets remained risk-friendly in May, with equities in advanced economies reaching the highest levels seen since the major bear phase started in early 2022.
- Bond yields have largely moved sideways as central banks have slowed the pace of tightening.
- These changes have been triggered by supply-side gains in commodity markets, labour markets and global supply chains. These gains are continuing.
- Aggregate demand seems adequate to support these supply-side gains for now, so recession risks appear limited at present.
- Core inflation is improving, but only very gradually.
“Sell in May and go away” is a tired old cliché among investment managers, but that does not automatically make it wrong. Will it prove correct this year? At the end of May, equity markets were continuing to defy the general mood of pessimism among many analysts (Figure 1). In retrospect, it seems clear that several powerful economic forces have been at work, making a soft landing appear more probable to investors than the consensus believed at the end of 2022.
Equities in the advanced economies have risen by 10.2 per cent (in local currencies) since the beginning of the year. In May, equities on the same definition rose by a further 1.8 per cent and are now at the top of their trading range for the calendar year. Among the Advanced Economies (AEs), Japan and the Euro Area have significantly outperformed the US and (especially) the UK markets (see Figure 1). An extraordinary feature of equity market performance this year has been the concentration of the market increase in only a few stocks, especially in the US where a boom in AI-related stocks has taken hold. Nevertheless, investors have been willing to acquire these AI stocks at rising prices for the overall markets, not at the expense of lower prices for stocks in other sectors. Macro forces have therefore been at work in driving the overall markets higher.
Figure 1: Equities Total Return, Local Currency (2023-01-01=100)¹
Although the major central banks have continued to raise their policy rates in May, this has come in smaller steps than before. The tightening in policy rates has therefore continued but hawkish monetary policy shocks – relative to the expected path for Federal Reserve and European Central Bank (ECB) policy at the start of the year – have been distinctly smaller than last year.
The Federal Open Market Committee (FOMC) is now widely expected to leave policy rates unchanged in June. We agree with current market pricing, though we would expect a clear message from Chair Powell that a further rise is possible in July and that cuts are not intended in the second half of the year. Meanwhile, the ECB may continue to sound hawkish for a short while longer but is unlikely to implement more than two further hikes of 25 bps each, given slowing Euro Area GDP growth and decelerating core inflation. Because central banks have been doing little more than the markets have priced in recent months, 10-year bond yields in the US and the Euro Area are almost unchanged over the year-to-date. The UK has been an exception, with nominal and real bond yields increasing by around 50bps this year (see Figure 2) reflecting much worse inflation data in the UK than elsewhere.
Figure 2: 10-Year Nominal Bond Yields²
This period of risk-friendly asset market performance has been driven by a series of benign economic shocks that have benefited output growth and inflation in the AEs, compared to the dire circumstances that existed in the first three quarters of 2022. The consensus forecast for world GDP growth in calendar year 2023 has risen by 0.7 percentage points since the end of 2022. Although much of this has been driven by China and other emerging economies, the consensus for the AEs has also moved slightly higher during the year. Meanwhile, headline inflation forecasts have remained almost unchanged this year.
The combination of higher GDP forecasts and unchanged inflation forecasts seems consistent with improvements in the supply side of the global economy, compared to what was expected for much of last year. In our view, there are three main reasons for the emergence of a supply-friendly regime in the global economy, and notably in the US, that has emerged in the past three quarters:
- The reversal of the energy and food shocks that did so much damage to the AEs last year represents a major supply side gain to those sectors of the world economy that consume these commodities. Energy prices are now almost back to their end-2021 levels and agricultural commodity prices have retraced about half of their increases (see Figure 3).
Figure 3: Commodities Total Return, USD (2023-01-01=100)³
- Labour markets have also seen major improvements from the supply side as the effects of the pandemic have abated. For example, in the US, the labour participation rate has risen from 61.5 per cent in December 2021 to 62.6 per cent now, increasing available labour supply by 6.1 million workers. Furthermore, the efficiency of the labour market in matching unfilled jobs to unemployed workers seems to be improving. This is demonstrated by the fact that the vacancies/unemployment ratio has fallen without any meaningful increase in the unemployment rate, and therefore without any recessionary shock to the economy. This has occurred because firms have reduced their desired number of vacancies without also laying off existing workers, so the Beveridge Curve has moved vertically downwards, rather than downwards and to the right, which would be more normal in an economic slowdown. We interpret this as a sign that the labour market is returning to the structural characteristics that existed before the pandemic, which implies that there is now more efficient matching of available workers to vacant jobs than was possible during the huge disruptions seen in the pandemic itself. It appears that this process of normalization has further to go, in which case wage pressures may continue to decline while the unemployment rate remains close to its current levels, a key requirement for a soft landing.
- Finally, the disruption to supply chains in the goods sector of the global economy has now been repaired, implying that goods can be supplied more efficiently to the relevant sources of demand. This reduces the costs of international trade and increases the gains from trade. The latest New York Fed supply chain pressure index shows that pressures have more than fully reversed the increase that occurred during the pandemic. In fact, the index is at its lowest ever pressure reading.
While these benign supply shocks remain in place, there are good prospects that core inflation will fall further. Hawkish monetary policy shocks will therefore be moderate, allowing the GDP growth rate in the advanced economies to stay well into positive territory, though probably below its long-term trend rate. However, even if the supply side remains constructive, as seems likely, it is entirely possible that demand growth will suddenly retrench sharply, because of the lagged effects of the cumulative monetary tightening that started in 2021 Q4. These effects include the inversion of yield curves and banking sector stresses in both the US and Euro Area in the last few quarters. These demand side forces could eventually produce a hard landing for the economy, even without a deterioration in supply side factors.
As noted above, developments during the month of May have been viewed optimistically by equity markets and by many commentators, on the grounds that resolution of the US debt crisis and stabilization of the US regional banking “crisis” have reduced the probability of a hard landing this year. We have built these assumptions into our central economic views for some time and therefore have no major change to our assessment of global activity data, compared to what we published here last week. Because of the continuing strength of labour markets and service sectors, it still seems likely that the current weakness in global manufacturing sectors will be insufficient to lead to recessions, though we repeat last week’s warning that the Euro Area appears more vulnerable to a significant downturn than the US. As always, these activity indicators require careful watching, since a recessionary end to the current cycle still seems fairly likely, though it does not appear to be imminent.