ClockWise: Interest rates may not fall without recessions

Arguably the most important events this year are the recessions that haven’t happened. Granted, the euro area economies, the UK and Japan are bouncing around the zero-growth line, but late last year severe recessions seemed likely.

Chinese growth has been disappointing, but it has improved since last year’s Covid lockdowns. And in the US, growth so far seems impervious to rate hikes. According to an Atlanta Fed indicator, annualised GDP growth for the third quarter is likely to come in above 5% in real terms, more than double its long-term trend.

Our base case is that central banks will ultimately succeed in reigning in growth, but fixed rate finance means the lags are long. In the meantime, government bond yields are pushing up against their cycle peaks. There’s a risk that this situation lasts longer than people expect if inflation inflects higher. Our global inflation scorecard has turned positive for the first time since the onset of the Ukraine war (chart 1), in part due to base effects – the oil price shock of the Russian invasion has dropped out of the year-on-year comparison – but also due to a more recent rise in oil prices and in manufacturing input price surveys. Without a recession to bring wage inflation under control, G7 inflation may edge up again going into 2024, forcing central banks to keep interest rates higher for longer.

Against this backdrop, it doesn’t surprise us that stocks have beaten government bonds by a wide margin since the UK mini budget panic a year ago. More recently, commodities have also started to rise again. With growth resilient and inflation starting to show signs of troughing, commodities could continue to beat bonds (chart 2). Recession risks remain going into 2024 as a sharp tightening in global monetary policy gradually feeds through into refinance costs. Before long, it could be right to move back to a more defensive stance, shifted in favour of government bonds and other safe haven investments.

Chart 1: Inflation Scorecard (6M lead) and G7 Inflation

Source: LSEG Datastream as at 15/07/2023

Chart 2: Commodities versus bonds and Royal London Asset Management nominal growth scorecard

Source: LSEG Datastream as at 08/09/2023

Market summary

Equity prices fell in a week where most asset classes posted negative returns. Investor sentiment soured, as stronger-than-expected US economic data renewed fears that rates may stay higher for longer and on news that China may restrict usage of Apple phones for government employees. In regions, Japan outperformed as the yen continued to weaken. At the sector level, tech underperformed while energy stocks outperformed as oil prices rose. In the week when yields in other regions rose, a more accommodating tone from the Bank of England saw UK 2-year yields fall while 10-year yields were flat.

Economics summary

Global activity slowed again in August according to PMI business surveys; US activity data has been very mixed. Meanwhile European Central Bank (ECB) and US Federal Reserve speakers continue to send somewhat mixed signals ahead of their September meetings and forecasters are almost evenly split on whether the ECB will pause or hike.

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