Markets react to peaking inflation data but it could also mean higher rates for longer

With central banks having reiterated their data-dependent approach for their future rate paths, we have seen increased volatility around each key data release.

Last week was no exception to this; a downside surprise in UK inflation data caused gilt yields to fall sharply and the pound to weaken, providing a relief rally for the beaten-up UK mid-cap stocks. Monday’s weaker than expected UK and euro area flash Purchasing Managers’ Indexes (PMIs) were also met with further falls in bond yields. The recent set of weaker manufacturing input prices from PMI surveys (chart 1) still point to lower goods inflation going forward, which has been taken positively by equity markets which are looking forward to the end of monetary policy tightening.

Chart 1: Input price surveys pointing to weaker goods inflation globally

Goods Consumer Price Index (CPI) and input prices – CPIs are YoY%; PMIs are balance of opinion indicators

Source: Refinitiv Datastream as at 15/06/2023

Investor sentiment has risen to euphoric territory, and we wonder if equity markets may be premature to celebrate the move lower in headline inflation, which has really been largely driven by falling energy prices. Services inflation remains stickier, highlighting domestically driven inflation still looks strong (chart 2).

Chart 2: Services CPI are still elevated

CPI: Services (%YoY) – Excluding energy services where classified as services

Source: Refinitiv Datastream as at 15/06/2023

It is possible to see wages moderate enough for central banks to shift to a looser policy without recessions, allowing equity markets to continue their positive run. However, lower goods inflation could provide a further boost to consumers who have been largely resilient, and this could lead to higher levels of services inflation to continue. If so, falling goods prices may counterintuitively force central banks to keep tighter policy for longer than it seems on the surface.

We are still positive on equities, but, like the central banks, we are also data dependent.

Market summary

Global equities gained on an index level while underlying components were mixed. The Dow Jones index rose 10 days in a row – its longest streak since February 2017, while Nasdaq pulled back on Tesla’s and Netflix’s earnings reports. UK shares outperformed regionally, driven by softer than expected UK inflation data. Weaker than expected Q2 GDP report for China saw Emerging Markets and Asia Pacific stocks fall. Gilts led sovereign bond prices higher as UK 2y fell below 5%. Peak rate pricing for Bank of England dropped to 5.8%, down ~70bps in two weeks.

Economics summary

Heading into a key week for central banks, the European PMIs came in softer than expected and moved further into contraction territory in July and business optimism deteriorated. US June hard data was on the weak side last week. Rate hikes are nevertheless expected for both the Federal Reserve and European Central Bank on Wednesday and Thursday respectively. Finally, we got a downside surprise in UK inflation. However, domestic inflation pressures still look strong…and enough to justify a 25bp rate hike in August.

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