15 May 2023: Hunt is still concerned about inflation

Although the UK’s economic performance in the first quarter was nothing to write home about, it was still far better than was forecast just a few months ago.

Q1 GDP grew overall by 0.1%. Construction, which has seen a significant rebound recently grew by 0.7% while the services sector, the major engine for growth in the country grew by 0.5%.

Despite this improvement, the economy is still 0.55% smaller than it was pre-Covid, making it the only country in G7 that is yet to achieve its pre-Pandemic peak.

Month-on-month the economy grew in January and February but fell back in March as strikes by railway workers and NHS staff bit into performance.

Even the launch of the new registration in March failed to provide its usual annual boost to the automotive market, with new car registrations at historic lows.

The quarter saw a welcome rise in manufacturing output, although this only makes up 20% of the overall economy.

With the return of energy prices close to pre-Pandemic levels, gas production saw a significant turnaround.

It is construction which feeds into several other areas of the economy, particularly the services sector that provided the most encouragement for future growth.

The first half of the year is still expected to be flat overall, with a boost provided by the Coronation offset by the additional Bank Holiday.

Most surveys and expert opinion appear to agree that the economy is starting to firm up, and although languishing at the bottom of the G7 league table, the outlook for the economy is becoming brighter.

One cloud on the horizon is the stubbornly high rate of inflation. The Bank of England raised short-term interest rates by a further quarter of a percent last week, bringing the base rate to 4.5%.

Following Andrew Bailey’s comments at the news conference following the announcement, there is a real possibility that rates will peak at 5%. The market had been expecting Bailey to hint at a pause in hikes, but inflation, in foodstuffs in particular, may preclude that for the rest of this quarter. The promise to halve the fate of inflation this year now looks exceedingly optimistic.

Last week, the pound challenged its high for the year but was unable to throw it conclusively and ended the week lower overall. It rose to a high of 1.2680 but fell back as the dollar recovered its poise to close at 1.2449.

Warren Buffett, the legendary investor, saw profits for his Berkshire Hathaway fund grow by more than $39 billion in the first quarter.

As a part of the release of his first quarter results, Buffett revealed several of his strategies for the coming months. He has lowered his holdings of equities while he looks for specific opportunities.

The “cash pile” of the company overall now stands at $130 billion, no doubt taking advantage of higher interest rates. Although his equity holdings are significantly lower than at the start of the year, he believes that an economic recovery in the U.S. will occur in the second half.

He sees interest rates rising further as the Federal Reserve continues its “obsession” with inflation.

This will see company earnings fall over the current quarter, in particular. The time has come to be more specific in stock picks over choosing sectors that will benefit due to specific circumstances.

The U.S. economy is expected to underperform as interest rates reach a restrictive level as the growth catches up with the fate hikes that have taken place already.

There is a degree of confusion over the next FOMC meeting, which will take place on June 13th and 14th. If the Central Bank is truly going to be driven by data, it will have a chance to react to both employment and inflation data which will both have been released by then.

If the headline rate of jobs created falls in line with expectations, while core inflation remains stubbornly high, the Fed and the market will be faced with a difficult decision.

This week, retail sales are the only tier-one piece of data due for release. A rebound is expected in the headline, as well as the ex-autos figures. Last month’s headline retail sales fell by 0.6% while in April they are likely to return to positive territory, gaining by 0.7%.

Last week, the dollar index was driven by the comparative economic outlook for G7 nations. There was a boost provided to the outlook by the Fed becoming more data-driven, which at least reduces the possibility that there will be another hike in June.

Rates are now at a critical stage, and while a recession is no longer the main view of many economists, it remains a possibility, however unlikely.

The dollar index rose to a high of 102.71 and closed at that level. It broke a long-running sequence where it had fallen over every week, bar one, since March 17th.

The Eurozone is suffering from a crisis of market confidence driven by a vague concern that a “banana skin” lies in wait for any marked improvement in the economic outlook.

A few weeks ago, everything appeared to be set “set fair” for a strong recovery for the economy, but since then the single currency appears to have stalled with traders unwilling to take significant long positions for fear about what may be “in the shadows”.

ECB Vice President and Governor of the Bank of Spain, Luis de Guindos, in an interview with Reuters last week, explained his concerns that any further rate hikes could see a significant increase in bad loans.

Rates have increased by 375 basis points since last July, and de Guindos feels that the time has come for the Central Bank to take a step back and look at the bigger picture.

Spain’s economy is currently performing above the Eurozone average, so the Bank of Spain Governor’s remarks are not to be taken with the usual pinch of salt whereby he is merely encouraging the more members of the Governing Council to take a stance that is more conducive to growth than fighting inflation.

De Guindos commented that the rate hike cycle has now reached the “home stretch”, and that is why rate increases have been a more normal twenty-five basis points rather than the fifty that had been a feature of more aggressive tightening of monetary policy.

The ECB is under pressure from the regulator over its perceived leniency in their treatment of bad loans. This highlights the concerns that the market has over the overall strength of the Eurozone economy and the willingness of the Central Bank to regulate the entire banking system in the absence of a Banking Union.

Last week, the single currency fell back to below the pivotal level of 1.10 versus the dollar. It fell to a low of 1.0848 and closed at that level. While this looks like a healthy correction that has removed the weak longs, it remains to be seen if the currency can stage a second attack on the 1.10 level which may be more successful.

This week, Q1 GDP data will be released, as well as preliminary inflation data. However, the week will be dominated by the path of the Euro which if it falls below support at 1.0780 may see a far deeper correction than has been seen so far.

Have a great day!