Weekly economic update: A Ray of Hope

By Rupert Thompson, Investment Strategist at Kingswood

Equity markets bounced strongly last week, posting their first weekly gain in nearly two months. Global equities rose 4.5% in local currency terms, leaving markets down 11% from their highs.

In a further reversal of recent trends, the US was the strongest performer, gaining 6.6% as growth stocks recouped a bit of their pronounced underperformance this year. UK equities saw a 2.6% rise while Asia and Emerging markets were broadly unchanged over the week.

The market bounce is in large part just an overdue technical correction to the fairly relentless decline seen over recent weeks. But it also reflects the fact that market valuations now look considerably more reasonable and appropriate for the new more stagflationary environment.

Certainly, there was no major news to drive the change in market direction. The Fed’s favourite measure of core US inflation did fall back to 4.9% in April from a high of 5.2% the previous month. But this was no big surprise and inflation remains well above the central bank’s comfort level.

Rate hikes of 0.5% are still very much on the cards at the next two Fed meetings. Beyond that, the outlook becomes somewhat murkier. While there is some talk now of the Fed potentially pausing in September, the Fed has also flagged the potential need to move to a restrictive stance rather than just a neutral one. We believe the Fed will most likely continue to raise rates into year-end but will be looking at 0.25% rather than 0.5% hikes by that stage.

Just as optimism had begun to build that inflation in the US may have peaked, oil has done its best to cast this into doubt. The Brent oil price, which had settled in a $100-110/bbl range, last week moved back up to $120 for the first time since March. Ongoing EU negotiations to agree a plan to restrict Russian oil imports are behind the rise, as is the continuing refusal of OPEC to step up its planned production increases.

Meanwhile, business confidence, which had been holding up surprisingly well, weakened significantly in May in the US, EU and UK. Even so, it remains comfortably above levels associated with a recession and the sharp fall in consumer sentiment in recent months is rather more of a concern.

The largest fall in business optimism was seen in the UK but this was followed in short order by the Chancellor’s latest move to alleviate the cost-of-living squeeze. Sunak announced a £15bn package of support measures with £9bn going to low income and vulnerable households. A third of the cost is to be funded by a 25% windfall tax on the profits of energy companies.

The package is worth around some 0.6% of GDP and should help avert the modest decline in the economy forecast by the Bank of England for later this year. This in turn makes it all the more likely that interest rates will be raised rather more than the Bank has been indicating. Rates look set to increase from their current 1% level to around 2% by year-end.

Last week’s bounce certainly does not mean markets are out of the woods yet and they look set to remain volatile over coming months. That said, it is an indication that if the markets’ worst fears are averted as we expect, equities should in time be able to recoup a good part of their losses.