Boiling the frog at the Fed and the ECB?

Financial markets’ current focus is for any sign of cracks in higher-frequency US labour market data. Leading economic data has suggested weakness in the pipeline in both the US and Europe. But maybe the post-pandemic economy really is different? Whatever the case is, the tenacity of inflation pressures is leading central banks to move monetary policy further into restrictive territory, raising risks of them going too far and ‘boiling the frog’ (overtightening into a recession).  

US factory activity contracted for 8th month in June

On 3 July, data was released showing the US ISM Manufacturing index fell to 46 in June, marking its lowest reading in three years and disappointing consensus expectations for a rise from May’s 46.9.

The commentary showed companies “began using layoffs to manage headcounts, to a greater extent than in prior months, amid mixed sentiment about when significant growth will return.”

The current stretch of readings below 50, which indicates shrinking activity, is the longest since 2008-2009. 

Fed poised to hike again

There was limited reaction from markets after the publication on 5 July of the minutes from the US Federal Reserve’s June monetary policy meeting. The Federal Open Market Committee minutes suggest the Fed intends to further moderate the pace of policy tightening – i.e., to something less than 25bp per meeting.

In a sign that the terminal rate is close, the minutes appeared to play down recent strength in both economic activity and the labour market, instead emphasising uncertainty around monetary lags and the credit impulse. The minutes also emphasised the importance of credit conditions.

Our macroeconomic research team expect the Fed to raise rates by 0.25bp at its meeting on 25-26 July and then once more in the third quarter, leading to a terminal level for the fed funds rate of 5.75%.

The risk is that economic resilience could support the desire of hawks on the committee for additional hikes. Our view is that materially weaker conditions in the US economy will ultimately dissuade policymakers from further action.

According to the minutes, ‘almost all’ officials who participated in the June FOMC meeting said that further increases in interest rates would be appropriate, citing risks including the ‘tight’ labour market.

After raising policy rates at 10 consecutive meetings, the Fed opted in June to pause and maintain the fed funds rate at a target range of between 5% and 5.25%. This was the first pause in its year-long campaign to rein in inflationary pressures.

Focus on US jobs data

Despite the Fed’s tightening of monetary policy, the labour market has remained remarkably strong over the last year. Investors are monitoring data closely for any signs of the market weakening.

The latest weekly data on US initial jobless claims (measuring the number of individuals who filed for unemployment insurance for the first time during the past week) showed first-time unemployment insurance claims were 248 000 last week (that is, through 06/07/2023). After revisions, the average for June was 254 000, that’s marginally higher than the level seen earlier in the year (220 000 in first quarter 2023).

Arguably then, a gradual weakening of conditions in the labour market may be underway, but not at all at the pace associated with recessionary conditions. As Fed Chair Powell put it during his May press conference: “It’s possible that this time is really different. And the reason is, there’s just so much excess demand, really, in the labour market.” 

Further data on the US labour market will come on 6 July with publication of the Job Openings and Labor Turnover Survey (JOLTS). This data will be studied closely for any sign of a sizable fall in job openings, pushing down the ratio of vacancies to unemployed persons (a measure favoured by  Chair Powell), which currently stands at 1.8. There have been indications in the Hiring Lab data that jobs openings in the US fell in May-June.

Finally, 7 July will see the nonfarm payrolls data for June published. Consensus estimates have underestimated the number of jobs created for 13 consecutive months by an average of 109,000. Underestimating job creation on this scale raises the question of whether the consensus is misunderstanding conditions in the post-pandemic economy and in particular the resilience of the labour market.

According to Bloomberg’s consensus forecasts, the report is expected to show that US payrolls rose by 225 000 in June (after 339 000 last month), while the unemployment rate slides lower, to 3.6%. At least as important, estimates suggest average hourly earnings will increase by 0.3% month over month and by 4.2% from a year ago. These latter numbers would be in line with the data for May.

Headline payrolls data may be supported by seasonal swings in state and local government hiring. As is the case across Europe, a lack of teachers – state and local government educational employment remains well below pre-Covid norms – could result in a smaller-than-usual seasonal swing in teacher/education layoffs. Barring a significant adjustment in seasonal factors, such a dynamic could be supportive of headline payrolls this summer.

Source: BLS, BNP Paribas Asset Management, as of 06/07/2023

Further signs of a sluggish rebound in China

Services sector activity expanded by less than expected in June, underlining the challenges facing the economy as the post-pandemic rebound disappoints.

Caixin’s services purchasing managers’ index (PMI) came in at 53.9 on 5 July, down from 57.1 in May and below consensus estimates. Readings above 50 indicate an expansion of economic activity.

The services sector has been recovering faster than the manufacturing sector. The manufacturing index came in at 50.5 in June after 50.9 in May.

Nascent sign of eurozone slowdown

On 5 July, publication of the eurozone’s composite PMI for June showed the index slipped to 49.9 from May’s 52.8. That was below the 50-mark for the first time since December and shy of a preliminary estimate of 50.3.

This is another data point suggesting a broad-based downturn is underway across the eurozone’s dominant services industry alongside signs of a deepening decline of factory output.

Eurozone producer prices – Negative territory for 1st time since 2020

Data published on 5 July showed eurozone producer prices fell into negative territory for the first time in two and a half years.

This is a further sign that the surge in prices across the eurozone is now in retreat. The EU’s statistics office, Eurostat, said factory gate prices in the region fell by 1.5% in the year to May, marking the first outright decline since December 2020.

The measure has fallen significantly since summer 2022, when annual price rises hit a peak of 43.3% in August after energy costs surged in the wake of Russia’s invasion of Ukraine. The decline will raise hopes that a series of rate rises by the European Central Bank is finally beginning to pay off.

Data this week suggested activity in Germany seems to have rebounded from the lows in March/April, with retail sales (+0.4% month-on-month) and new industrial orders (+6.4% month-on-month) rising in May. Data on car production in June pointed to a further improvement in the second quarter.

However, such numbers are hard to reconcile with survey data (S&P Global Europe Sector PMIifo survey), which instead points to ongoing contraction in the manufacturing sector.

Looking ahead, our macroeconomic research team expects an improvement in consumption, driven by lower inflation, and in manufacturing activity on the back of lower energy prices, despite headwinds from tighter monetary and fiscal policy. But all in all, it sees the German economy stagnating for the rest of the year.

Holding the course

In this environment, our multi-asset portfolio management team sees equity valuations in the US and Europe as rich and earnings estimates as optimistic. Its equity market temperature framework is flashing danger ahead. Areas where it is cautiously positioned (Europe and the US) stand out here, with some emerging market regions notably attractive.

Significant moves higher in fixed income, with higher terminal rates, should provide good risk-reward opportunities in areas where it sees greater downside growth risks. In its view, commodities continue to bake in a lot of bad news.


Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk. Private assets are investment opportunities that are unavailable through public markets such as stock exchanges. They enable investors to directly profit from long-term investment themes and can provide access to specialist sectors or industries, such as infrastructure, real estate, private equity and other alternatives that are difficult to access through traditional means. Private assets do, however, require careful consideration, as they tend to have high minimum investment levels and may be complex and illiquid.

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