UK asst prices on hold, as central banks talk tough

As we move towards the second half of the year, investors are starting to question what themes will dominate financial markets in the coming months. Inflation is still front and centre, along with what central bankers will do next. Global growth, and the potential for central bankers to achieve a soft landing is also in question, along with the next theme to drive global stocks. The underlying assumption seems to be that commodity prices will continue to moderate or remain stable, while the war in Ukraine will rumble on in the background and Chinese growth will be lacklustre. If these assumptions do not go to plan, then it could have large ramifications for asset prices and for volatility.

The Fed pivots back to rate hikes

As we move towards the end of the week, the commentary from the world’s central bankers in Portugal is dominating the market. While the Bank of England, the ECB and the Fed all struck hawkish notes, the Bank of Japan stuck to its dovish mantra, and the market has reacted. US stocks were lacklustre on Wednesday as they digested the prospect of higher interest rates. There is now an 81% chance of a 25bp rate hike from the Federal Reserve in July to 5.25-5.5%, according to the CMC Fedwatch tool. The interest rate market has completely reversed course and has priced out the prospect of interest rate cuts for this year. There is now more than 50% probability that US interest rates will stay at the 5.25-5.5% level by the end of 2023 and the market seems unsure about the prospect of rate cuts next year. There is only a 36% chance of one 25bp rate cut by March 2024. A month ago, there was a 30% chance that interest rates would be 4.5-4.75% by March 2024. This is a large shift, yet US stock markets have managed to rally regardless.

Why are risky assets so resilient?

The market resilience in the face of a more hawkish Federal Reserve is puzzling. Usually, higher interest rates hurt stock prices, especially tech stocks. However, this has not been the case in recent weeks. The Nasdaq index rose by nearly 0.3% on Wednesday, even though central bank speak was notably hawkish. Even though there were some deep losses for AI stocks on Wednesday, it looks like some of these losses will be reversed on Thursday. For example, Nvidia’s share price fell 1.8% on Wednesdays, yet it is expected to rise by more than 1.1% at the open on Thursday. Nvidia’s share price has fallen by more than 5.8% so far this week, however, if we see a recovery on Thursday, it suggests that the recent weakness in AI share prices may be temporary, and some investors may use it as an opportunity to go long. This is significant, since it may suggest that AI stocks, which some argue are over-valued, could see further upside in the second half of the year. However, we do not expect another 176% gain in the second half of the year, rather if AI stocks like Nvidia can continue to rally, we expect gains to be more moderate.

The US stock market rally broadens out

One of the most fascinating aspects of stock market performance in recent weeks is that the rally in the US has been broadening out, even though expectations for interest rate hikes in the US have increased. Stocks that are nearing a 52-week high include Apple, DR Horton, Lennar, Carnival, Norwegian, Cardinal Health, United Air, Fedex, Vulcan and Lowe’s along with others. The purpose of this list is to show you that the stock market rally in the US is not as narrow as some argue, which is a sign that this stock market rally is gaining health and could have legs. The stock market is not acting like the economy is dying, but instead that the prospects of a recession are dying, and this is significant as we move through to the second half of the year.

Inflation and stock markets

Elsewhere, there seems to be a correlation between countries that have been able to bring inflation under control and domestic stock market performance. European stocks are higher on Thursday, as further signs emerged that the ECB is winning the fight against inflation. Spanish CPI that has been harmonised to the EU, fell to 1.6% in June, down from 2.9% in May. This is technically deflation territory, however, this sharp decline in Spanish CPI, which is a lead indicator for overall Eurozone inflation, is largely due to favourable base effects from 2022. Thus, the improvement in the Eurozone’s inflation position serves to highlight the challenge faced by the UK, that can’t even get headline inflation down in a significant way. It also suggests that stock market performance is correlated with domestic inflation levels, and this could be why UK stocks are struggling compared to their peers. What was most surprising to us at Minerva Analysis, was BOE governor Andrew Bailey’s lack of contrition around inflation forecasts during his panel discussion in Portugal on Wednesday, along with his fairly laissez faire view that inflation would fall further. Either he knows that UK inflation will decline sharply from here, or he needs to take our inflation problems more seriously.

What’s next for GBP

In the FX space, we have already noted that short term interest rate differentials are one of the biggest drivers of FX moves in recent months. We expect this to continue with one exception – the pound. GBP/USD is the weakest performer in the G7 FX space this Thursday. After being the best performer in the G7 FX space in Q2, GBP/USD has backed away from $1.28 highs and is trading around $1.2650. GBP/USD has risen more than 5% in the last 6 months and is thus due some pullback. Whether or not GBP falls meaningfully from here will depend on the economic data. If it looks like the economy is struggling then expect some GBP weakness, even if short term bond yields rise. UK economic data on Thursday showed weaker consumer credit for May, along with lower net lending to individuals, however, mortgage approvals rose more than expected to 50.52k, compared to 49.7k expected. We expect mortgage approvals to fall later this year, as the housing market struggles under the burden of surging interest rates, but in the short term we expect labour market data and inflation data to be the key driver of GBP in the second half of this year.

The dollar and where it may go next

Elsewhere, USD/JPY has backed away from 7-month highs on Tuesday, even though the Bank of Japan governor hinted that Japan will not be dropping its zero-interest rate policy this year. However, we think that USD/JPY remains at risk from excess volatility, especially if the BOJ decides to intervene to strengthen the yen. Usually when reports come out that Japanese officials will defend their currency and take steps to strengthen it, this can goad the market and it may lead to further USD/JPY strength in the short term. The dollar index is down some 1.42% this month, and losses have gained pace in recent months. However, if we see that 1, Eurozone inflation falls broadly in June, and 2, if UK economic data is weaker than expected, then we could see the dollar strengthen in the second half of this year.

Kathleen Brooks