Lop-sided recovery has driven wage inflation
The service side of the economy have been buoyant, while manufacturing has been hamstrung by weaker demand and excess inventory. This has meant growth has been squeezed into labour-intensive and low-productivity areas of the economy, driving up employment, wages and inflation.
Sticky inflation may require recessions in developed economies if central banks are to hit 2% inflation targets. Central banks have responded with very rapid interest rate increases – though starting from zero means that the first 2% or so of the increase should be regarded as simply taking the foot off the accelerator.
We forecast a mild US recession starting at the end of the year. That means that US equities will struggle, but other economies and asset markets appear less synchronized.
Tale of Two Sectors
Global Purchasing Manager' Indices
Source: Columbia Threadneedle Investments and Bloomberg as at 26 June 2023
The Fed’s intervention after the collapse of Silicon Valley Bank has averted the risk of a credit crunch. However, that still leaves a credit squeeze as lenders turn more cautious. There is a lot of monetary tightening already in the pipeline. We agree that there will likely be two more interest rate increases this year, with cuts to be expected next year.
Covid support measures enabled the US consumer to single-handedly fend off recession in 2022. Covid piggy banks – excess savings accumulated during the pandemic – exhausted and repayments on student loans set to resume in September, we expect a mild recession to start at the end of the year.
A mild recession should be sufficient to take pressure off the tight labour market and so ease wage inflation, allowing inflation to continue its decline towards the Fed’s target.
Wage inflation still too high
Source: Bloomberg as at 26 June 2023 and Columbia Threadneedle Investments as at 27 June 2023
Note: Fed Wage Tracker based on Atlanta Federal Reserve series minus 0.6% to reflect bias versus ECI
Europe’s weak patch is puzzling
We are puzzled by how weak the European economy has become. European consumer confidence has rebounded from historic lows, their Covid piggybanks remain unspent, natural gas prices are now a fraction of their peak and real wages are set to rise. That should underpin a recovery from the current soft patch.
We may be simply looking at the wrong things. Economic statistics focus on easier-to-measure manufacturing sectors and investors look to those from the largest economy, Germany. Manufacturing has been weaker than the harder-to-measure services sectors, while German manufacturing has been especially hard hit by the closure or relocation of businesses reliant on cheap Russian natural gas. Other indicators, such as Spanish retail volumes up by 6% on the year, show a stronger picture.
We expect that European Central Bank will continue tightening monetary policy through the year. They will be focused on the strong growth of wages and the potential for the economy to accelerate as consumer spending picks up.
Wage growth accelerating in euro area
Euro area negotiated pay growth
Source: Columbia Threadneedle Investments and J.P. Morgan at 16 February 2023. Image source: pigsels.com. Estimate and forecasts are provided for illustrative purpose only. They are not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
UK is an outlier on inflation ... but improvement on the way
The UK is an outlier with core inflation heading higher, even as it turns lower in the US and rest of Europe. There has been a spike in pay growth around the indexation uplift to the minimum wage, while the annual uplift of social security payments has also surged into the economy.
Fixed-rate mortgages, combined with other trends in the mortgage and housing market, mean that the pain of rising interest rate is not widely spread, with 80% of the impact yet to come. This means we expect house prices to fall further, by around 10%, though that would still leave them well above pre-Covid levels.
We have revised our inflation forecast up but still think that inflation it will fall sharply by the end of this year, to around 4%, helped by the rebound of sterling cutting import prices. However, there will be little scope for tax cuts as government debt costs have soared with rising interest rates.
The Bank of England has little confidence in its ability to forecast future inflation given its recent string of failures. But the alternative, using the latest inflation figures as a guide, means that it is effectively driving monetary policy by looking in the rear-view mirror.
Core inflation heads north in the UK
Source: Columbia Threadneedle Investments and Bloomberg as at 27 June 2023. Image source: imagesARRTFF8F_stock snap.
Equities to struggle in US but Japan looks attractive
Every US recession has been accompanied by weakness in the stock market. While the consensus is for earnings growth to be negative for the S&P 500 over the next year, we do not think that forecasts fully reflect the likely fall in profits.
While we expect equities to struggle in the US, Japan looks attractive. Japanese companies are increasingly focused on returning surplus cash balances to investors. The Tokyo Stock Exchange is requiring any company with a share price below book value to come up with a plan to address the issue.
We see plenty of pockets of value in risk assets, given that the US recession is likely to be mild and that the recent advances by US equities have been concentrated in a handful of stocks. We see a turnaround in the UK market next year and expect that emerging markets will be resilient given that, without the questionable benefits of Covid piggybanks and quantitative easing, they have already hiked interest rates and undergone the necessary economic adjustments.
The real return on US Treasury Inflation-Protected Securities (TIPS) 10-year bond is 1.5%. That’s more than twice the level pre-Covid and well above the -1.0% prevailing at the height of quantitative easing. We think that this offers a reasonably attractive yield on the closest thing to a low-risk investment. On this basis, we continue to broadly favour government bonds.
Japanese companies start to focus on shareholder value
TOPIX aggregate net income and share buyback announcements
Source: Columbia Threadneedle Investments, BofA Global Research, QUICK and J.P. Morgan Asset Management as at 27 June 2023. Based on TOPIX companies fiscal year ending in March. Share buybacks aggregated from April 1st to May 18th for each year.