Spring Economic Upswing

Spring Economic Upswing Amid Market Shifts

A relatively calm week has provided a generally favourable environment for risk assets, with recent data indicating that the economy may be warming up during the Spring months. As external risk perceptions diminish, global risk assets have been steadily increasing.

The UK economy experienced a decline in retail sales volumes for March, partially attributed to cold weather, as reported by the Office for National Statistics (ONS). Excluding fuel, retail goods volumes fell by 1% compared to February. Food prices continue to rise faster than other goods, as evidenced by the over 10% increase in banana prices. On the other hand, the Chartered Institute of Procurement & Supply indices reveal an upswing in services, with the Services Purchasing Managers Index (PMI) rising unexpectedly from 52.2 to 53.9. Services new orders stand at 55.3, and the services employment index climbed two points to 52.0, signalling a stronger hiring surge and higher pay settlements.

Higher pay settlements are likely a key factor in the substantial improvement in consumer confidence. Although the GfK Consumer Confidence index increased sharply, a better indicator is the rate of change in confidence, which has markedly improved from a 40-year low to a 40-year high, according to our calculations. The Bank of England (BoE) had anticipated a contraction of -0.35% (or 1.5% annualized) in second-quarter growth, so the latest data will be significant and likely ensure another rate hike on May 11. Markets are already accounting for an additional 0.5% increase, which both consumers and large businesses appear able to bear, but which will further strain smaller companies.

Market volatility continued to decrease last week, contributing to higher prices. Central banks will maintain pressure until inflation is under control, raising rates until stress leads to failures. While riskier assets’ yields may appear attractive compared to low price movements, stress remains. As a result, this is not a Goldilocks environment characterized by low rates, low profitability, and low stress. Valuations may become more expensive, but the risks are too high to justify an overweight position.

Corporate earnings season is underway, with just 17% of S&P 500 companies having reported quarterly results thus far. Results are mixed but generally better than consensus. For the 86 companies that have reported, earnings have decreased by 1% year-on-year, beating analyst expectations of a 6-7% decline. Positive surprises amounted to 5%, but as usual, corporate earnings surprises should be taken with caution. Over the past five years, S&P companies have exceeded quarterly earnings expectations by an average of 8.4%. If this trend continues, we could expect a slightly positive year-on-year growth in earnings, which is not what we are currently seeing. In fact, surprises are quite varied across sectors. Although US equities have outperformed modest expectations so far, the S&P has mostly traded sideways over the past week.

Few European companies have reported quarterly earnings yet, but estimates have risen in the first few months of the year, with only a slight decline in March. European EPS estimates for 2023 are flat, with sales holding steady but profit margins under pressure. This could leave European equities in a vulnerable position. Investors had a negative outlook for European corporate earnings in the latter half of last year, but those concerns were not fully realized due to a better-than-expected winter. Now that some optimism is priced in, disappointment may be on the horizon.

Following the failures of Silicon Valley Bank (SVB) and Signature Bank, American deposits have flowed out of commercial banks. Smaller regional banks have experienced significant outflows, but not all of the cash has gone to larger banks. Instead, many Americans have turned to money market funds (MMFs). Since the beginning of March, over $440 billion has poured into US MMFs, according to data provider EPFR, building on strong inflows that have been ongoing for more than a year, thanks to the US Federal Reserve (Fed)’s aggressive monetary tightening and the higher interest rates it brought.

For some investors, the inherent diversification of the underlying fund portfolios is seen as a better risk than a deposit with a single bank. The most crucial factor, however, is that MMFs offer higher interest rates than savings accounts. Larger banks have not needed to work hard to attract deposits, so MMFs can currently offer customers a compelling premium while easily persuading the financially literate and wealthy that the risks are actually lower. The difference between bank deposit rates and MMF rates has widened over the past year, partly due to the Fed’s aggressive monetary tightening.

Higher returns offered by MMFs, along with turmoil in the banking system, make them an almost obvious investment choice, but there are risks involved. The debt ceiling, an annual political showdown that perpetually threatens a default in the world’s largest economy, could cause a liquidity crunch, making it harder for MMFs to buy or sell their assets and potentially leading to losses. Banks would argue that MMF investors would not be protected against these threats, unlike traditional bank accounts.

In the event of a genuine run on MMFs, the Fed would likely intervene to safeguard investor capital, just as authorities went beyond their official remit to protect SVB customers. The Fed demonstrated this during the pandemic when they increased reverse repo rates to effectively guarantee a minimum level of returns for MMFs. The reason is that MMFs have become so systemically important that the US financial system would likely seize up without them. As a result, Fed protection provides MMFs with some of the safest short-term options available.

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This article is for information purposes only – should not be perceived as financial advice. We recommend you should always speak to a financial adviser before making any investment decisions.

Please note, past performance is not a reliable indicator to future returns. Your investment may fall as well as rise, and you may not get back what you put in.