31 August 2023: Business optimism is improving

There continue to be more mixed signals this week for the UK economy as a measure of business optimism rose to its highest level since before the Russian invasion of Ukraine, but housing market activity was shown to be 20% lower than it was a year ago.

As has been the case in most stories about the economy this year, the Bank of England is behind both headlines. The rises in interest rates that have been taking place for close to twenty months have not just had a significant effect on the headline number of home sales this year, but related trades and services have also been hit.

The optimism being shown by businesses is because there is a growing feeling that although inflation remains well above the Government’s target an end to the cycle of hikes may be in sight.

So far there are none of the telltale signs of an economy on the verge of a recession, like business failures or a significant drop in money supply, but despite the optimism there is also a degree of caution.

A prominent economist and journalist spoke yesterday of his disappointment at the collective weakness of the Monetary Policy Committee who he likened to a flock of sheep blindly following their shepherd.

Andrew Bailey, the shepherd in this scenario, is considered unable to use the required imagination of his predecessors and clearly believes that monetary policy is something that can only be created “by the book.”

In the period since his appointment Bailey has had several situations to deal with that could hardly be considered as normal. The Russian invasion of Ukraine, the Pandemic, and the execution of the Brexit protocols have all been “bumps in the road” but Bailey has not been sufficiently proactive or imaginative.

Independent members of the committee have spoken of their differing opinions on what the MPC should do, and voted accordingly, but “groupthink” has consistently meant that they are little more than a “voice in the darkness.”

The Bank of England’s investigation into profiteering by companies taking advantage of inflation to maintain or improve their profit margins has been completed with no substantial evidence being found. On the contrary the report found that profit margins had been squeezed as business absorbed additional costs to maintain market share,

The pound as expected has been driven this week by activity in other markets. Yesterday it climbed to a high of 1.2746 as the market was disappointed by data published in the U.S. It eventually drifted back a little to close at 1.2721.

There was a major change to the cozy feeling of a soft landing for the U.S. economy yesterday as the data for Q2 GDP was revised down from 2.2% to 2%.

Suddenly everything is being looked at through a lens of an economic downturn. Public sector job creation fell to 177k from an expected 195k which would have usually led to comments that the market is cooling in line with Fed expectations, but considering the weaker GDP data it is now seen as a harbinger of dark times to come.

This places even more significance on tomorrow’s non-farm payroll number which will be published as part of the August employment report.

The current expectation is for 170k new jobs to have been created, down from 187k in July, but fears are growing that this may be the month when the rate hikes agreed by the FOMC finally bite and the data may be far weaker than has been anticipated.

It is all a matter of confidence. Something that Jerome Powell has worked tirelessly to instil in the market while continuing to be realistic about monetary policy. His slightly downbeat speech last week at the Fed’s Symposium is now being looked at in an entirely different light.

The warning that the Fed is still considering more rate hikes later in the year, is now seen as a far more dangerous move, especially since inflation is still falling even as the pause in hikes that was agreed in June feeds through into the system.

There has been little or no mention of a recession over the past few months as a soft landing became several economists and analysts best guess for the economy.

Now with GDP having been revised lower that sense of optimism has been severely dented and today’s Personal Consumption Expenditures data which is a precursor of CPI figures due for release next week may play into renewed market fears of stagflation.

This is the power that one poor piece of data can have on a market that remains unconvinced of the likelihood of a “Goldilocks Scenario.” The next 48 hours will go some way to providing a little more clarity.

The dollar index reacted badly to the GDP data, falling to a low of 102.92, as a pause in the cycle of rate hikes became more possible. It recovered to close at 103.16 as a sense of reality returned to the market later in the day.

ECB President, Christine Lagarde appears to have done some deep thinking while on holiday earlier this month and has concluded that if it is not the data that is feeding the economic models that is wrong, then the models themselves need to be revised.

Lagarde simply cannot accept that the path that the ECB has been on for the past year in which it has consistently hiked interest rates to tackle inflation has had the effect of driving the Eurozone economy close to a recession.

Although the Eurozone still has its head just about above water, two of its more prominent economies, Germany and Italy are suffering a recession that is yet to be confirmed, while others are experiencing downturns which may turn into economic contractions if the cycle of hikes is not halted soon.

There is still support for a further hike at this next month’s meeting with two hawkish members of the Governing Council, Latvian Martins Kazaks, and Austrian Robert Holzman both questioning a pause in hikes in September.

Next month’s meeting has become more important than simply being the first after the summer lull. Members of the Committee will have had two months’ data to pore over, while the extended gap between meetings will have had the effect of a pause.

There is still no confidence in the market about whether there will be a pause of a further hike. The constant mention of the Bank being data-driven that is a personal favourite of its Chief Economist is little more than an excuse for the action that is taken than the reason.

It has been obvious for some time that there are three factions on the Governing Council. The hawks led by Holzman, Kazaks and Bundesbank President Nagel, the doves led by the Ignazio Visco from Italy, and the realists led incongruously by Banque de France Governor, Francois Villeroy de Galhau.

The hawks have been holding sway but as the data becomes increasingly indicative of an economy approaching a recession, the doves have become stronger there has been less support shown by the likes of The Netherlands and Belgium whose economies are beginning to waver.

The Euro has been propped up recently by the expectation that the ECB will continue to tighten monetary policy for longer than the Fed, and yesterday’s data bore that out. This led it to rally to a high of 1.0945 although as a sense of reality set in it drifted back to close at 1.0923.

Have a great day!