EQUITY AND BOND MARKETS BENEFIT AS US INFLATION DROPS TO ITS LOWEST IN TWO YEARS

EQUITY AND BOND MARKETS BENEFIT AS US INFLATION DROPS TO ITS LOWEST IN TWO YEARS

This week brought a significant shift in the narrative surrounding inflation. US headline inflation dropped to 3% in June. Core inflation has been more resilient than the headline rate but it also fell. Despite the Federal Reserve expected to keep hiking in the very short term, the speed of the decline was enough to buoy financial markets around the world as investors look forward to the end of US interest rate hikes and a weaker dollar. Government bonds rallied strongly, and equity markets also looked to the positive.

A soft landing remains a realistic outcome in the US and economically-sensitive equities saw some of the biggest gains. But the reaction in the UK appears optimistic in the face of otherwise gloomy updates. The Bank of England now expects average mortgage payments to go up by £3,000 a year, and potential buyers are being put off by high borrowing costs. Company insolvencies are expected to keep rising and unemployment is also up, despite more than 1 million vacancies still open. In the face of these headwinds, the BoE can only to look to the US with envy.

US: MARKETS WELCOME NEWS OF RAPIDLY COOLING INFLATION

A sharp drop in US inflation helped lift financial markets as US inflation dropped to its lowest in over two years. Headline CPI inflation dropped from 4% to 3% in June. Core inflation (excluding volatile food and energy costs) declined more slowly from 5.3% to 4.8%. Recent strong employment data means a rate hike this month remains a strong possibility, however, investors consider the outlook for interest rates to be much more positive and see the Federal Reserve getting closer to the end of its rate hiking cycle.

The better inflation reading helped lift government bonds in the US and the UK, sending yields down sharply. Equity markets also welcomed the slower inflation reading. The tech- heavy Nasdaq index in the US rose by 1.2% on Wednesday and UK and European equities were even more positive. Sterling and the euro rose to their highest level against the dollar in more than a year as the European Central Bank and Bank of England are widely seen as having further rate hikes to come as inflation is more persistent than the US.

UK: GDP CONTRACTS IN MAY AS RISING RATES TAKE EFFECT

UK GDP shrank in May, however, the decline was smaller than expected. GDP fell 0.1% between April and May as output from manufacturing and construction declined. GDP was unchanged for the three months to the end of May compared to the previous three months. Average wages increased by 7.3%, but unemployment ticked up to 4% and job vacancies continued to fall.

Other signs of growing stress in the UK include a sharp drop in activity in the property market. The Royal Institution of Chartered Surveyors reported sentiment at its most negative in 14 years as mortgage borrowing costs surge and estate agency Winkworth issued a profits warning due to falling sales. The Bank of England predicted the average mortgage borrower will pay almost £3,000 a year more due to higher mortgage rates. Meanwhile insolvency practitioner Begbies Traynor reported full year revenues up by 11% due to the rising number of bankruptcies and it predicts many more companies will fail due to borrowing costs rising.

MARKETS: DEFENSE SECTOR BENEFITS AS SECURITY GAINS IMPORTANCE

Arms companies are reaping the benefit of higher government spending in the aftermath of Russia’s invasion of Ukraine. This week BAE Systems received an order of up to £400m for the production of artillery shells as the UK and other western governments rebuild stocks rundown by assistance to Ukraine. Other UK defence companies have also reported a surge in government spending. FTSE 250-listed Chemring recently reported a record £750m increase in its orders over the last 18 months.

The increase in spending is not just in the UK. European Nato states have been repeatedly criticised for failing to meet Nato’s target of spending 2% of GDP on defence. Since Russia’s invasion, many countries have increased spending to close the gap and Nato members recently voted to make 2% of GDP the minimum level of spending on defence. The priority given to defence spending has driven a sharp rise in defence and aerospace stocks and has made this one of the best performing sectors in the last 18 months.