Fed chair Powell reiterates recession risk, as pound has respite for now

Here at Minerva Analysis, we have two themes that we are watching closely: firstly, when sentiment towards risky assets will change, and secondly, why the pound’s decline could continue. Today was a lesson in the fact that market themes, and prices, do not move in a straight line. The S&P 500 reversed its recent rally on Wednesday and declined slightly in an uneventful day for markets. The key theme was a rally in Treasuries (yields fell) and the dollar also dropped. This weighed on USD/JPY, which dropped a notch to the 136.00 level, while GBP/USD rose back above the $1.2260 level after a fresh high in UK inflation caused expectations to rise that the BOE will need to match the Fed’s pace of rate hikes to bring price growth under control. Now, it’s hard to see risk sentiment change, although the pace of the recent sell off has slowed. So far this week, trading action has lacked any specific catalysts and the broader narrative remains recession risks continue to grow as global monetary policy starts to bite.

US recession risk signals flash red, which could limit recovery rally

The key event this week was Fed chair Jerome Powell’s testimony to Congress. After last week’s FOMC meeting and their 75bp rate hike, we didn’t expect that he would change his message too much in a matter of days, and we were correct. He repeated to Congress that the US economy was strong enough to withstand the rate hikes, but that future monetary policy tightening does increase the chances of a recession, although he also pointed out that the recession risk is not elevated right now, even if growth is showing signs of slowing down. Economists at Citi said that recession risk for the US economy is now 50%, Citi’s economic surprise index is also at its lowest level since the peak of the pandemic.

Earnings fears next big concern for markets

In the current environment, it is fundamental factors that are driving risk assets. As the macroeconomic picture deteriorates, this is weighing on stock prices, and it is why US equity indices are in a bear market. Although inextricably linked, we look at the macro picture from two sides: growth and inflation. The growth side is flashing red with rising recessionary risks. The next big test for market nerves will be Q2 earnings season at the start of July. The risk of a disappointing earnings season is growing with the US recession risk. The key fear is that analysts remain too upbeat about blue chip corporate profit margins, and this could set companies share prices up to fail, as a slowing economy and rising input costs weigh on the corporate bottom line. The inflation picture is also becoming more complex, the prospect of inflation falling in the next few months also seems very dim. In the UK and the US, fears are growing that there will be a wage/ price spiral that will keep inflation elevated for longer. This is starting to show through in the economic data: the San Francisco Fed estimate that supply issues account for 50% of the surge in US inflation, with demand side pressures accounting for 30% of the increase. There are two ways of looking at this: 1, the demand side is putting more upward pressure on inflation, which is bad. 2, The Fed and other central banks have more power to control demand-side inflation with mega rate hikes, thus the Fed and other central banks could bring down inflation in the coming months, although they could choke growth in the process.

Why stocks could continue to come under downward pressure

The reason for this spiel, is that there are no best-case scenarios that could save the day right now, even the 4.5% decline in the price of Brent crude oil on Wednesday is unlikely to boost sentiment in the long term. It will hurt the FTSE 100 because of the large concentration of oil producers that are in the UK index, and it may even depress the mood further as oil falls on the back of a growing recession risk. The market is taking the Fed and other officials at their word, and they are sounding negative, and dare we say it nervous, about the economic outlook and what they must do to get it back on track.

GBP woes continue to build

The pound may have recovered slightly on Wednesday, but this was not on the back of a change in heart towards the pound by the FX trading community. Instead, it was mostly driven by the weaker dollar. The list of factors that are weighing on the pound is still growing: the highest level of CPI in the G7 and the prospect that the inflation will stay higher in the UK for longer compared to our peers, a slowing economy, real wages falling at a record pace, a rising debt cost due to our current account deficit, and the prospect of a potential debt crisis on the back of the depreciating pound causing the buyers of UK debt to demand a higher premium for lending us money. These are powerful reasons not to get too attached to the pound right now. We think that we will oscillate in the $1.20 region vs. the USD for some time, with EUR/GBP also set for a rebound back to the mid-June highs around the 0.8700 mark as the Eurozone sorts out its fragmentation problem in the peripheral European bond market. Thus, GBP/USD may be a sell on rallies in the medium-term.