[the US] "...not as strong as she seems”
Rick Astley, Cry for Help
Last week, we discussed a number of factors, from the concentration of elections in EM (India, S, Africa and Mexico) and the significance of the data releases this week to the rising dominance of the growth factor in the monetary policy reaction function. The elections in India, South Africa and Mexico all brought with them significant volatility in financial markets (in the case of India and South Africa because the incumbent underperformed expectations, driving uncertainty over the shape and constituents of coalition governments and in the case of Mexico because the ‘continuity’ candidate outperformed expectations such that concerns over changes to the constitution undermined confidence). However, in all three instances we are minded to see the ultimate outcomes as far more stable than the initial fears and market volatility suggested.
Not as strong as it seems
On the growth front, there have been several first-tier data releases this week. Manufacturing ISM, at the start of the week, continued to highlight weakness in the sector with the headline index, prices paid and new orders sub-indices falling further into contraction. Employment did, however, rise above the 50 expansion line.
For some months now, we have stated our view that the US consumer is not likely as strong as the headline data suggests. Indeed, this is also a view we have expressed (more forcefully) in the UK. Recent data in the US has begun to show clearer signs that the consumer momentum that drove the services-led inflation boom of the past few years is starting to fade. Forward guidance from consumer-focused equity earnings releases earlier this month and even the personal spending component of the PCE report further adds to signs of consumption slowdown.
Disinflation and growth moderation
If we take this argument a little further, in the US, we have seen significant improvements in the supply of labour (via substantial immigration) and further improvements in the demand for labour (the demonstrable further decline in JOLTS job opening data this week), indicating a notable loosening of labour market conditions. If we add to that the noteworthy decline in the employment sub-index of the service sector PMI, then we can make the case that not only is the heat coming out of the labour market, but that the ‘sticky’ part of the inflation complex - services, predominantly a function of wages - is shaping to provide sufficient confidence that inflation is returning to target at the Fed.
On the growth front, we also note that the GDP Nowcast from the Atlanta Fed has declined sharply over recent days to stand currently at 1.8% quarter on quarter annualised in Q2. This is significant not only because earlier in the month, the same measure was tracking above 4% but notably because it is now below the Fed’s (recently upgraded) estimate of equilibrium growth. If we add the fact that rates are “well into” restrictive territory, then it is indicative that rate cuts are consistent with returning inflation to target.
Essentially, the data evolution is starting to more clearly align with our long-held view of disinflation and growth moderation.
A ‘hawkish cut’
Over recent months there has been a clear theme in relation to market sentiment towards ECB growth, inflation and rates - negative divergence to the US. We have maintained the view that the situation is worse than the market is pricing (as above) in the US and is likely better than expected in Europe. In short, we have disagreed with the divergence story that the market has been so keen to price. Rather, we see policy, rate and growth convergence.
This week, it was the ECB, and they duly cut 25bps as expected (and well telegraphed). However, it could clearly be characterised as a ‘hawkish cut’. The statement removed the sentence “it would be appropriate to reduce the current level of monetary policy restriction”, and the general narrative about the future path of rates was intentionally and specifically cautious. The updated projections also gave a more hawkish bias, with inflation forecasts revised higher by two-tenths in both 2024 and 2025. Although it could be argued that the inflation forecast being unchanged at the policy-relevant forecast horizon leaves the direction of travel on rates unchanged, the upgrades to the near-term forecasts go against the first (and possibly second) of the ECB’s three criteria for cutting rates - i) the inflation outlook, ii) the path of underlying inflation and iii) the transmission of monetary policy.
Essentially, it was clear (as it was with the Bank of Canada this week) that while the ECB are broadly comfortable with the direction of travel of European rates (from restrictive territory), there is sufficient uncertainty in both the European data and the policy reaction function of the Fed that the ECB are very cautious in cutting ahead of the Fed.
The Long & Short of it…
The combination of continued disinflation and growth moderation in the US – or, in other words, lower but still positive growth plus a looser labour market - in conjunction with a current policy rate in restrictive territory is a macro configuration that likely has significant consequences for markets. From our perspective, this should be positive for bonds and equities (particularly long-duration equities such as tech). Furthermore, given our views that the right tail risks to inflation and, thus, growth have diminished and the US growth trajectory has more clearly converged with the rest of the world, we are increasingly of the view that the backdrop is supportive of a (perhaps significantly) weaker USD. Particularly if, as we suspect (and to paraphrase Rick Astley), the US is not as strong as she seems!
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