When bad news is good news

When bad news is good news

Last month we noted how stronger than expected growth was pushing up market expectations for interest rates, raising mortgage and corporate loan rates. In the UK this pattern of good economic news creating bad news in terms of rising interest rates has gone into reverse in the last month. Interest rate expectations have fallen back as signs of weakness in the economy have mounted.

• Last week the latest Purchasing Managers' survey showed that private sector service activity unexpectedly contracted in July, reversing the resilience seen in the sector in the early part of the year. The weakening of manufacturing activity that has been seen in the survey since mid-2022 accelerated deeper into contractionary territory in July. Inflationary pressures have eased, with the survey showing input costs and prices charged by companies falling back.

• The labour market is also showing signs of cooling, with the UK unemployment rate rising from 3.9% in the first quarter to 4.2% in the second quarter.

• The housing and construction sectors show the clearest signs of slowdown. House prices have fallen by 3.8% in the last year, according to the Nationwide house price index, though this is trivial set against growth of 23% in the preceding two years. Housing activity has borne the brunt of the downturn, with a sharp deceleration in mortgage approvals and house sales hitting shares in estate agents and housebuilders. Last week the Financial Times reported that insolvencies in the construction sector have risen by 17% over the last year, the fastest rate of growth in a decade.

• While growth has weakened the slowdown has been less pronounced than expected at the start of the year and the damage to the wider economy limited. This far into a major tightening of monetary policy, with interest rates having risen by almost 485bp since late 2021, one might have expected greater damage to have been visited on the economy in terms of redundancies, insolvencies and mortgage late payments.

• This may be about to change. Last week the Bank of England warned of a growing risk of corporate defaults. The Bank forecasts that the share of non-financial UK companies experiencing debt-servicing stress - defined as having a low ratio of earnings to interest expenses - will rise to 50% by the end of this year, up from 45% in 2022. Among medium size companies, those with an annual turnover of £10m to £500m, the proportion of companies at risk of distress rose to 70%.

• The recent run of weaker data has curbed financial market expectations for future interest rate increases. Markets see base rates, which are currently 5.0%, reaching a peak of about 5.75% towards the end of this year. As recently as early July market had been pricing in a peak in rates of 6.5%. Mortgage rates have edged slightly lower, with the average rate for a five-year fixed 85% loan-to-value mortgage at 5.82%.

• UK activity has slowed in the last year shows that monetary policy is working. The question the Bank of England faces is whether the slowdown will come sufficiently quickly to bring inflation back to its 2.0% target within the prescribed two-year forecast horizon. The fact that both underlying inflation and average earnings are running at almost 7.0% suggests inflationary pressures have spread from commodities and food prices into the wider economy. We think the Bank is likely to continue to raise rates, with a 25bp hike likely at its policy meeting on 21 September and at least a further 25bp rate rise before the end of the year.

• UK activity has slowed, but not buckled, as interest rates have risen. As rates move higher, and the impact of earlier rate hikes feed through to consumers and corporates, the stress on the economy will increase. The countervailing effect of falling inflation should soften the blow, bolstering consumer spending power and easing the pressure on margins. The hope is that lower inflation will help ride to the rescue of an economy facing the full effects of higher interest rates. This is the path the US seems, so far, to be following (US inflation fell from over 9.0% last summer to just 3.1% in July while momentum in the economy has picked up).

• A recession-free purging of inflation, what some call an “immaculate disinflation” is the dream of every central banker. For the UK that outcome looks more likely today than it did a year ago. But it is not assured.  

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 1.1% at 7,524. The index rebounded after a significant fall last week as interest rate expectations moderated.

Economics

• Early estimates of activity in August from surveys of Purchasing Managers suggest a greater than expected contraction in activity in the euro area and UK and a slowdown in growth in the US
• Manufacturing activity is estimated to have declined across the US, euro area and UK while the services sectors in the UK and euro area is also thought to have contracted
• US Fed chair Jay Powell said that: “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective”
• UK energy regulator Ofgem announced that the cap on a typical household energy bill will fall from £2,074 to £1,923 in October, down £577 on last winter
• UK consumer confidence rebounded in August after a drop in July while euro area consumer confidence fell unexpectedly
• UK public sector borrowing in July came in at £4.3bn, the fifth-highest July since records began but below market expectations prompting calls from some Conservative MPs for the government to cut taxes later this year
• Online property portal Rightmove reported that the asking prices for UK house dropped by 1.9% in August, the largest monthly fall for August since 2018
• The UK government is expected to confirm a fifth delay to post-Brexit border checks on food coming from the EU amid fears it could contribute to inflationary pressures
• An influential survey of German businesses conducted by the Ifo Institute showed business sentiment falling to a ten-month low as businesses grew increasingly pessimistic about current and future conditions
• Amid concern over a slowdown in the Chinese economy, the People’s Bank of China modestly cut a benchmark interest rate
• The US criticised China’s decision to stop publishing some economic data that had shown weakness in the world’s second largest economy as damaging to confidence in China’s economy
• The yield on US government bonds hit a 16-year high last week as robust economic data support the case for the Fed keeping interest rates at a high level
• China has imported record amounts of semiconductor equipment ahead of an impending ban by the US and its allies

Business

• Chipmaker Nvidia reported that its revenue more than doubled in the second quarter as surging demand for processing power to train AI models drove sales
• Chip designer Arm published a preliminary prospectus for its planned stock market listing. The initial public offering is expected to be the biggest in nearly two years
• Bosses in the FTSE 100 received a 16% pay rise on average last year to reach a median of £3.9m, according to the High Pay Centre
• India landed a rover on the moon
• Some 20,000 members of the UK’s RMT rail union and senior NHS doctors went on strike on Saturday in disputes over pay
• The UK’s Serious Fraud Office dropped a ten-year corruption investigation into Kazakh mining company ENRC due to ‘insufficient admissible evidence’

Global and political developments

• A study by a Ukrainian think tank found that over 90% of Ukrainians oppose territorial concessions in order to end the war
• The US will begin training Ukrainian pilots on the F-16 fighter jet
• Yevgeny Prizoghin, head of Russian mercenary group Wagner and leader of a failed uprising in June, was killed in an unexplained plane crash. The Kremlin denied involvement 
• Former US president Donald Trump was arrested for the fourth time this year on charges of election interference in Georgia
• Emerging market group BRICS (Brazil, Russia, India, China, South Africa) invited Argentina, Ethiopia, Iran, Saudi Arabia and the UAE to join as the group seeks to provide a counterweight to existing multilateral organisations such as the G7
• China has offered to build a nuclear-power plant in Saudi Arabia, the Wall Street Journal reports. The US has previously said that any US nuclear aid to the kingdom would be dependent on non-proliferation conditions, something that China is not reportedly seeking
• Japan released treated radioactive water from the failed Fukushima nuclear power plant into the Pacific despite protests from China
• UK shadow chancellor Rachel Reeves said the Labour Party has no plans for a wealth tax and ruled out higher charges on capital gains and property income

And finally… a large black bear nicknamed Hank the Tank, responsible for 21 home break ins in South Lake Tahoe California has been apprehended by wildlife authorities – bearfaced burglar