Russia, interest rates and recession risk

The biggest news story of the weekend was Russia and its failed coup. The march of the Wagner group of Russian mercenaries to Moscow, which was halted almost as soon as it began, was a clear reminder that the political situation in the world’s largest nuclear power has the potential to de-stabilise financial markets at a moment’s notice. The unexpected nature of Saturday’s rebellion has led the British government to warn that the UK must prepare for the sudden collapse of Russia, and instability within President Putin’s regime. This escalation in tensions in Russia has not been reflected in financial markets, the Brent crude price has fallen at the start of trading this week, and a barrel of Brent now costs $74.20. The Russian Rouble is also stable. We think this is a short-term reaction, and a sigh of relief after Russia avoided a near-term coup. However, the ongoing risks of Russia falling into a power vacuum may well be reflected in stronger commodity prices in the long term, due to Russia’s critical position as one of the world’s largest commodity producers.

PMI data paints bleak picture

Global stocks had their worst week since March last week, as fears rose about even higher interest rates and weak economic growth. Russia’s political situation is likely to weigh further on stocks, as another risk factor will need to be priced in. Friday’s preliminary PMI data for June weighed heavily on sentiment as Europe, the US and the UK all saw sharp declines in their manufacturing and service sector PMIs. In the Eurozone, the composite PMI fell to 50.3 down from 52.8 in May, in the UK, the composite PMI fell to 52.8 down from 54, in the US, the composite PMI fell to 53, from 54.3. While the Eurozone has the worst figure and is only clinging on to expansionary territory at 50.3, the speed of the declines in activity in the US and the UK is also a cause for concern. Manufacturing activity is deep in contraction territory in the US, Europe, and the UK, and has been for some time. Weakness in manufacturing is now spreading to the service sector in the West, which is bad news for economic growth as we move into the second half of the year.

UK investors pile into bonds

The fact that central bankers are also prioritising the fight against inflation over supporting economic growth, and it’s no wonder that stocks are struggling. The UK’s stock market saw its 24th straight week of outflows last week. Instead, investors are piling into UK gilts due to the 5% plus yield on two-year paper, which is more than you will get if you put your money into a bank account. It is worth remembering that the US regional banking crisis that started back in March, was driven by savers pulling their money out of banks and instead opting to put their money into mutual funds that mirror interest rate increases. While we don’t think that UK banks are as exposed to deposit flight, it will be interesting to see if depositors have moved their money out of UK banks in recent months.

The government joins in the fight against inflation

The UK’s fight against inflation is still a key theme for financial markets at the start of a new week. The government is set to join the Bank of England in its fight to bring price growth back to the Bank’s 2% target. The Prime Minister hinted at the weekend that he may not agree to recommendations from public sector pay review bodies for pay rises in the 2023/24 year. This has been met with disbelief from Trade Unions and is likely to lead to more strikes down the line. The economic rationale for not increasing pay is sound, however, the timing is bad as the cost-of-living crisis continues to bite. There are other efforts that the government plan to take to try and bring inflation down in the coming months. The Chancellor of the Exchequer is set to meet the Competition and Markets authority to stop “greedflation” from taking control, he is also meeting with energy, water, and communications watch dogs this week. While we doubt that the UK will go down a price control route, a la France, it shows that the government is willing to throw itself into the fight against inflation. Supermarket bosses will also be grilled by MPs this week and scrutinised to see if they are making excess profits from food inflation that is running at more than 18% per year. However, Q1 results show that supermarket profit is largely stable, which weakens the case that they are profiteering.

Higher interest rates inevitable

The world economy is at an interesting juncture, that could make it hard for stocks to advance in the medium term. We think that the bias is to the upside for bond yields (lower bond prices), as the spectre of entrenched inflation dominates the narrative. UK interest rates are now expected to rise to 6.25% by February 2024, which is a further 5 standard rate hikes from where we are now. Thus, the fastest tightening in monetary conditions is unlikely to slow any time soon. However, recession risks are growing, and German and UK bond markets are flashing warning signals. The German yield curve is inverted to the tune of 70 basis points, in the UK it is inverted by 80 basis points, the most inverted it has been since 2000.

Overall, risks are mounting for the global economy, and stagflation – where inflation remains high as growth falters - is front and centre. In this environment we expect the dollar to recover, stocks to flounder and bonds to continue to decline. It’s not a pretty picture as we start a new week.