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Khatija Haque - Head of Research & Chief Economist
Published Date: 17 August 2022
US equity markets have rallied over the last month and a half, with the S&P 500 index up around 16% since it’s mid-June low, and the tech-heavy Nasdaq composite index up by more than 20% over the same period – the technical definition of a bull market. The rally has confounded many analysts, coming as it has against a backdrop of slowing growth and high inflation.
Recession fears have increased in recent weeks, with economic data showing a slowdown in manufacturing activity, rising jobless claims and a second quarter of declining GDP in the US. This is reflected in the most inverted yield curve since 2000. In the US, an inverted yield curve, where 10-year treasuries yield less than 2-year ones, has historically predicted an economic recession with a high degree of accuracy. The rally in equities even as macroeconomic conditions are seemingly worsening reflects the market’s belief that the Federal Reserve will have to cut rates in 2023, as inflation slows and unemployment rises.
July’s inflation data, which came in better than expected last week, provided further support for this view. Headline CPI fell to 8.5% in July, down from a multi-decade high of 9.1% in June, but this was largely due to lower energy prices. Core inflation, which excludes volatile food and energy prices, was unchanged at 5.9% y/y last month, reflecting sustained inflation in housing, healthcare and other services.
Fed officials quickly pushed back against the market’s rosy interpretation that the central bank won’t have to raise rates as much as previously thought, now that consumer inflation has seemingly peaked. Several Fed presidents noted that they still expect rates to rise into 2023, and that although the July inflation print was a good one, they will need more evidence of a sustained decline in price pressures before they consider a change in policy.
The argument that inflation has peaked also assumes no further supply shocks with respect to energy and food. While global oil and food commodity prices have eased in recent weeks, and there are indications that food exports from Ukraine are resuming, any further disruptions to supply or a recovery in demand could again put upward pressure on these key commodities.
OPEC+ has limited capacity to increase production, and the war in Ukraine means that energy supplies from Russia to the EU remain constrained and could be disrupted further, potentially causing shortages this winter. China’s demand for oil is also expected to rebound as Covid19 related restrictions on activity are eased, and the IEA has recently increased its forecast for oil demand growth this year, saying that high natural gas prices are encouraging firms and power generators to switch from gas to oil, particularly in Europe and the Middle East.
While we are optimistic that inflation will continue to ease in the coming months, the pace of decline is likely to be slow. Indeed, headline and core CPI will remain well above the Fed’s 2% goal by year-end.
Meanwhile, the US labour market still looks exceptionally strong, with another 528k jobs added in July and a further decline in the unemployment rate to 3.5%. Consequently, we expect the Fed will continue tightening monetary policy in order to cool demand and forecast another 150bp in rate hikes over the rest of this year.
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