Weekly view - Geopolitical recession
In the US, January retail sales figures, persistent services inflation, and a January producer price index figure that surprised on the upside helped spur calls for further 50 bps rate increases from some Fed officials last week. While our base case is that the Fed will raise rates by 25 bps twice by the end of May before stopping, sticky producer prices will hurt corporate margins. Yet, despite a rise in bond yields, the S&P 500 barely dropped and the tech-oriented Nasdaq actually ended the week higher. This means the risk premium for US equities (the excess return they offer over risk-free government bonds) has fallen to its lowest since 2007. Given margin pressure that is eating into earnings, high valuations and reduced prospects for rate cuts, we remain cautious on equities overall, especially US equities. We are encouraged in this stance by geopolitical developments developments, which remain an important investment theme. US companies are starting to be blacklisted by China (one company for selling arms to Taiwan) while last week a Dutch chip manufacturer accused an ex-worker of disclosing secrets in China.
Brussels continues to develop its response to the US Inflation Reduction Act, with a chance that NextGen EU funds are aimed even more precisely at preserving and protecting native EU industries. Countries may also be granted more fiscal flexibility under an overhauled Growth and Stability pact— a potential game changer for how countries manage their budgets. So far in the 4Q earnings season, positive surprises from European companies have outstripped those seen in the US. Large European exporters and luxury names have benefitted from Chinese reopening, while bank earnings have also been surprising positively. These figures, combined with lower valuations, meant European equities outperformed US stocks last week, as they have since the start of the year. Yet European Central Bank (ECB) board member Isabel Schnabel warned in an interview that markets may be underestimating the inflation risks. In short, the dichotomy between equity market performance and the trajectory of interest rates is the number one challenge for investors. The Scottish first minister Nicola Sturgeon resigned last week. This is good news for the Labour Party but possibly not for Scottish independence. Meanwhile, average pay in the UK rose at an annual rate of 6.7% in Q4 2022 – higher than expected.
In China, credit data for January surprised on the upside, mostly driven by loans to corporates. But household credit remained weak, indicating that demand for mortgages remains low. We expect the People’ Bank of China to continue easing policy to try to help stabilise house prices. In the meantime, the extent of China’s rebound will need to be watched closely as households' wealth and sentiment remains tightly linked to the property sector. This week, our focus will be purchasing manager indexes in Europe and the US as well as the University of Michigan’s consumer sentiment index for January.