A fortnightly look at global financial markets

• Global stock markets consolidating

• Market returns to pricing in Fed cuts later in the year

• Bond markets more apprehensive of U.S recession

• China’s 5% growth target under pressure 

• Sterling up…and taxes?

• Some ideas on boosting U.K growth

Market sentiment: Stock markets are consolidating around levels seen a month ago, holding onto decent year-to-date returns. Investors appear to be pricing in a soft landing for the U.S economy, confident that the Fed can bring down inflation without inducing a recession, and that a fresh global economic cycle will start late this year/ early 2024. Interest rates may have peaked in the U.S, and are likely to peak over the summer in the U.K and elsewhere in Europe, with less damage to underlying economic growth than had been expected at the start of the year. Relatively good first quarter corporate earnings in North America and Europe also support investor confidence.

Conditions in the U.S. The U.S bank crisis rumbles on, but with little impact outside the American financials sector. The debt ceiling crisis is impacting on short-dated Treasury bills, with yields sharply higher than overnight bank rates at the one to three month maturities, on fear of default. This has created a very odd-looking Treasury yield curve, with a large hump at the short end before sharply inverting. But there is little evidence of debt ceiling anxiety in other asset classes.

Strong U.S labour market data last Friday included a fall in unemployment and continued wages growth. This is unusual after more than a year of rate hikes, and some analysts speculated that the Fed may have to raise interest rates again in June. It is, in part, a reflection of a low labour participation rate relative to pre-Covid times.

But yesterday’s slightly lower-than-expected U.S inflation numbers have alleviated those fears, and the market is again confident that last week’s Fed rate hike to 5%-5.25% represents the peak of the current cycle, and is back to pricing in two 25pb rate cuts in the autumn/winter. 

Bears point to the inversion of the Treasury yield curve as a lead indicator of recession, and to the risk of more things breaking in the financial sector under the pressure of high interest rates. And certainly the bond market appears to be more cautious, and less confident of a soft landing for the U.S economy. Goldman Sachs are forecasting the low point for the U.S economy will be in the third quarter, with just 0.5% GDP growth at an annualised rate, and so escaping recession. 

Indeed, while there appears good reason for the Fed to pause its rate hikes at current levels, there seems less evidence to support rate cuts later this year, given that wage growth is climbing. The risk of a recession, caused by the Fed prioritising inflation over growth, remains. We shall see. 

Conditions in China. News earlier this week of a surprise fall in imports into China has led to unease over the durability of the country’s post-Covid economic recovery. Imports were down 7.9% year-on-year in April, much worse than the 0.2% contraction that was expected. First quarter GDP growth, reported three weeks ago, was 4.5% year-on-year, and officials were confident that 2023 annual growth could reach 5%. That now appears in doubt. 

The most obvious problem is slowing demand for China’s exports of manufactured goods, as global growth weakens in response to central banks’ squeeze on inflation. China’s purchasing managers index (PMI), that measures industrial activity, fell from 51.9 in March to 49.2 in April. Anything below 50 indicates contraction. Although showing solid gains from their October 2022 lows, many China-related stock markets peaked in late January and have been drifting south since.

Sterling. The pound has a fair wind behind it with a year-high of $1.26 and a six-month high of Euro 1.15. Helped by better than expected growth and public finances. The prolonged recession, forecasted by the Bank of England last autumn, has failed to materialise, but the second and third quarter GDP are expected by many economists to show a contraction. 

Today’s Bank of England meeting is likely to see interest rates rise 25pbs, to 4.5%. A further rate hike is expected by the markets, before a pause in order for the Bank to assess the impact of its rate hikes to date. This will add further support to the pound, particularly given that the Fed may have already paused its rate hikes, and many FX analysts think the dollar will weaken once a new economic cycle kicks in and risk appetite returns to global capital markets. 

Pragmatism comes too late for the Conservative Party. An additional boost for sterling has come from politics. The U.K Prime Minister Rishi Sunak, and Chancellor Jeremy Hunt, are bringing stability back to economic policy and public finances. They have reached agreement for the basis of a workable deal with Brussels over Northern Ireland/ G.B trade. Large parts, if not all, of the Retained E.U Law (Revocation and Reform) Bill look like being shelved. (This bill has been pushed by Brexit supporters to free British business of inherited E.U law, but businesses have pushed back because they need to comply with E.U laws in order to trade with the bloc. Assurances by the bills’ supporters that workers’ rights, and environmental standards, would be maintained under replacement U.K legislation, have been greeted with some scepticism). 

Abandoning the E.U Law bill -which Sunak explicitly supported, when he first ran for Prime Minister last summer- demonstrates a welcome pragmatism. But it is unlikely to be enough to prevent a Labour election victory at the next general election, or at the least a Labour-dominated coalition with other parties. The next election has to be before 28th January 2025.

Labour and taxes. Kier Starmer, leader of the Labour Party, has done much to make the party appear moderate once more in the eyes of the electorate. But the British electorate want -as the cliché goes – ‘European public services, paid for with American tax rates’. It is likely that Labour will square the circle by improving public services through higher taxes. Sluggish long-term GDP forecasts for the U.K suggest that keeping tax rates at current levels will not produce the necessary revenue. No tax plans have been announced, but we can expect the increased tax burden to fall on those with middle and high incomes.

How to boost growth, and so generate more tax revenue without raising tax rates? Here are some (not particularly original, but all politically difficult, ideas):

1. Relax planning restrictions to allow more building.

2. Higher immigration (of people with skill levels above the U.K average).

3. Re-negotiate Brexit, to Theresa May’s half-in/half-out November 2018 deal. This would include freedom of movement of people, in return for freedom of movement of goods and services.

4. Improve labour participation rates to pre-Covid levels for young mothers and over 55’s through fiscal incentives.

5. Encourage investment in start-ups and small companies by pension funds, by reviewing post-Maxwell pension rules and the abolition of tax credits on dividends for pension funds.

Investors should, as always, remain diversified across asset classes in order to maximise returns per unit of risk (volatility) suffered.