10.03.22

September and the third quarter mercifully conclude

The last week’s market highlights:

  • Markets couldn’t overcome a panicky start to the week. Because the U.K. government launched an ill-advised fiscal stimulus plan amid near record-high levels of inflation, the British pound approached an all-time low versus the U.S. dollar. This forced a mid-week intervention by the Bank of England to stabilize the country’s bond market and currency.
  • In the U.S., the S&P 500 (-2.9%) suffered its third straight week of losses and sixth in the last seven, with rising interest rates considered likely to hurt corporate profits in the coming quarters.1
  • The U.S. 10-year Treasury yield briefly topped 4% during intraday trading on Wednesday before closing at 3.83% on Friday.2 Despite the retreat, the rate on the bellwether security rose for the ninth consecutive week.3 (Bond yields and prices move in opposite directions.) Meanwhile, the broad U.S. investment-grade bond market fell 4.5% for the quarter, close to the 5.3% decline sustained by the S&P 500 Index.4
  • Friday brings September’s U.S. employment report, which should show continued healthy job creation and low unemployment. Because unemployment claims have been declining, the economy may add more than the 250,000 payrolls forecast. Investors will express particular interest in average hourly earnings given the Fed’s focus on cooling wage growth.

Each week, we present our featured topics in the context of the major themes from Nuveen’s most recent global investment outlookOpens in a new window:

  • U.S. economy: Recession has become a 50/50 proposition by the end of next year.
  • Global economy: High commodity prices threaten emerging markets and energy importers.
  • Policy watch: Central banks are tightening but now risk going too fast, too far.
  • Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
  • Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
  • Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.

Quote of the week:

"World turning, I gotta get my feet back on the ground. World turning, everybody's got me down."  –  Fleetwood Mac

The U.K.’s monetary and fiscal policy is not the markets’ “cup of tea”

The U.K. has endured a rough stretch. First, legions of admirers mourned the death of Queen Elizabeth II. Then, legions of investors tried to make sense of the miniature financial crisis emanating from London.

The Bank of England’s Monetary Policy Committee (MPC) began hiking rates last November and has amped up its tightening as inflation reached record highs over the summer. But on September 23 — seemingly at cross purposes with the MPC’s actions — the U.K. government announced a fiscal stimulus package, or “mini budget,” including steep income tax cuts and direct subsidies to help consumers pay for rising energy costs, courtesy of the war in Ukraine.

Markets quickly expressed their displeasure with the proposal:

  • The British pound plummeted, approaching an all-time low versus the U.S. dollar, as investors cast doubts about the merits of putting money in people’s pockets while a central bank is raising borrowing costs. A falling currency increases the costs of imports, adding to inflation. That’s not a path the MPC cares to travel.
  • Yields on 5-year gilts (U.K. government bonds) soared almost 100 basis points in the two trading days after the plan’s announcement.5 Since the package will be financed by issuing government debt rather than by cutting spending, the surge in gilts anticipated to flood the market sent yields sharply higher.

The MPC sprang into action to tame the turmoil. Last Wednesday, September 28, it vowed to buy unlimited quantities of gilts in a bid to (1) prevent a further drop in the pound and (2) stabilize the gilt market, which had been exhibiting disorderly trading as yields gapped higher. Keep in mind that at the same time, the central bank is expected to keep aggressively raising short-term rates to cool inflation.

The open-ended commitment to purchase bonds was especially notable because the MPC had been considered one of the most hawkish central banks, its gaze fixed entirely on lowering prices. While the program is, in practice, very similar to quantitative easing, a strategy designed to heat up the economy, its primary purpose was to reduce panic among pension funds, whose bond holdings lost about half their value in just a few days.

Such a push-pull dynamic between fiscal and monetary policy is usually reserved for emerging market countries, where central banks generally have less independence from their incumbent governments. In this case, while the MPC’s independence isn’t in question, it was forced to repair the damage done by the ill-timed mini-budget rollout to forestall even more severe market reactions.

For now, it seems the MPC has stopped the bleeding. Gilt yields stopped rising in the wake of the bond-buying operation’s announcement, though they were still far higher than their levels from just a few days prior. The pound appeared to have found a bottom against the dollar and the euro but remained at a very weak level against both.

It’s important to contrast last week’s upswing in U.K. rates with the steady ascent in U.S. rates. Yields have risen in the U.S. because investors believe the Federal Reserve will make good on its plan to stay in tightening mode until inflation falls close to its 2% target. Chair Jerome Powell and his colleagues are keen to avoid repeating the Fed’s mistakes in the 1970s, when policymakers prematurely began cutting rates amid weakening inflation. And sure enough, inflation flared up again. Partly for this reason, the U.S. dollar remains the currency of choice for investors seeking a safe-haven. It has strengthened against nearly all of its peers this year, and foreign inflows into U.S. Treasuries have been substantial, showing that the skittishness in the investor community about owning gilts doesn’t apply to the Treasury market.

But across the Atlantic, rates are rising because the MPC will likely have to hike more aggressively than previously forecast, and markets are losing trust in the government to spend within its means.

The U.S. is far from recession, despite the Fed’s “best efforts” to slow the economy

Although recession fears persist, U.S. economic data overall has exceeded forecasts over the past three months in the face of 225 basis points (bps) of tightening from the Federal Reserve over that stretch (and 300 bps for 2022 as a whole). Last week featured a full data docket that helped “take the temperature” of the U.S. economy. The results may have been mixed, but they still point to positive, albeit modest, third-quarter GDP growth after consecutive quarters of contracting economic output.

Highlights included:

  • Capital goods orders surged in August and were revised upward for July.
  • Last month’s trade deficit in goods was narrower than anticipated, as exports fell less than imports. Meanwhile, wholesale inventory growth accelerated. After detracting from GDP growth for the first two quarters of 2022, both categories should contribute in the third quarter. Moreover, the inventory buildup, which boosts supply, could help slow the rate of price increases in the economy’s goods-based sectors.
  • Home sales bounced in August, although their six-month average is still plummeting. Home prices fell in July, according to the Case-Shiller 20-City Home Price Index, but remain +16% year over year.6
  • Initial jobless claims maintained their decline, which began in mid-July. Continuing claims have also been decreasing over the past few weeks, indicating that anecdotal evidence about layoffs in the retail and technology sectors doesn’t necessarily reflect broader trends in the labor market.
  • Personal income and consumer spending matched or topped forecasts in August. Spending continues to outpace inflation, fueled by strong job creation and low personal savings rates.

August’s inflation data, however, was too hot for comfort. The “core” Personal Consumption Expenditures (PCE) Price Index, which excludes food and energy costs and is the Fed’s preferred inflation gauge, increased 0.6% in August and 4.9% year over year. Headline PCE rose 0.3% last month and 6.2% over the past 12 months.7 Clearly, the Fed has more work to do before declaring victory over rising prices.

Against this dizzying data backdrop, investors may be wondering if bad economic news — mainly on the jobs front — is necessary for the Fed to think it’s succeeded on its inflation-fighting mission so it can begin loosening policy. Not in our view. We’re looking for job openings to fall as the labor force expands, a combination with the potential to cool the labor market and wage growth without actually driving up the unemployment rate. As we see it, this is the path to a soft (or “softish”) landing that could provide a catalyst for better returns on stocks, corporate bonds and Treasuries.

Sources:
  1. Bloomberg
  2. Bloomberg, Federal Reserve via Haver
  3. Bloomberg
  4. Bloomberg
  5. Bloomberg
  6. spglobal.com
  7. Bureau of Economic Analysis

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.

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