After the carnage wrought by the hawkish US central bank in January, it was Europe’s turn last week. First up, the Bank of England, which delivered a 25 basis point hike in the base rate; no surprise there.
But it was only the casting vote of Governor Andrew Bailey that stopped the rise being 50 basis points. And that was a surprise. He followed that with an ill-judged suggestion on the BBC’s Today programme that workers should exercise pay restraint. As he’s paid a shade under half a million pounds a year, that hasn’t gone down well, including at 10 Downing Street, which is exercising restraint of a different kind.
Big jump in European inflation forces Lagarde to act
Next up, European Central Bank President Christine Lagarde, who abandoned her promise to keep monetary policy loose for the foreseeable future. The European bond market went into convulsions, with yields on German bonds rising into positive territory and 10-year Italian bond yields jumping by a remarkable 46 basis points. The euro reversed its decline and rose against all major currencies. Madame Lagarde was responding to a big jump in inflation in January – not just energy prices but across the board, with a particularly large surprise rise in Germany.
European equities fell heavily over the week and underperformed the US. Again, sharply reversing the previous pattern. The US market also saw the biggest ever one day decline in market cap terms – the company previously known as Facebook – which was subsequently followed by the biggest rise when Amazon reported the following day.
Central bank tightening lessens the threat of recession
There is no doubt that equities hate rising rates. But the fact that the US Federal Reserve (Fed) are tightening now means that the risk of recession in 2023 – which I highlighted in my Closing Bell webinar in December – has fallen. The Fed and other central banks were ‘behind the curve’, accelerating towards a bend in the road with their feet firmly on the gas. That’s the way to swerve into a recessionary ditch. By taking their foot off the accelerator and gently applying the brakes, the Fed is more likely to keep the car on the road. Recession is a much greater threat to equities than rising interest rates.
Of course, US consumers are struggling as both rising inflation and the expiry of the Child Tax Credit following the failure of Biden’s Build Back Better Budget squeeze incomes. But overall incomes are rising faster than inflation, with wages and employment strong. There may be a wobble in US growth this quarter but I’m confident that there’ll be no recession in 2022.
Economic strength evident in the US; a different story for Europe
That strength in the US economy is also evident in S&P earnings reports. Earnings are coming in 9 percentage points better than expected before the reporting season began. Indeed, the size of the beats rose last week, one of the reasons why US equities outperformed.
It’s a different story in Europe; yes, employment is growing, but add the growth in jobs to the rise in wages and you still fall short of inflation. We are paying much higher energy prices in the UK than in the US, and wages in the UK and Europe are growing more slowly.
Inflation in Europe a shock, but risk assets should recover
I did think European inflation would rise in January and I do expect wages in the UK and Europe to accelerate over the next few months. But I was shocked by the scale of the rise in January inflation in Europe, and the flip flopping of the Bank of England. I remain bearish on bonds and that will restrain equities. There’ll be more volatility now that central banks have put themselves into play, but the global recovery is robust and that means we should see risk assets recover.
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