Look out for What they say, not What they do

There are widespread expectations that the Fed will impose a 25 basis point rate hike this week, but the markets will be more keen on what the Fed has to say rather than what it actually does. What compounds the problem for the US central bank is that the US economy remains quite robust. 

• The Atlanta Fed estimates that second quarter real GDP growth in the US has run at a seasonally adjusted annualised rate of 2.4%.
• Conditions in the labour market remain strong with close to full employment. The number of job openings has started to rise again.
• There are signs that inflation could re-accelerate. Gasoline and oil prices have both risen recently. Householders’ perception of inflation has also risen; the University of Michigan’s 5-10 year inflation expectation is at 3.1%, at the upper end of the recent range.
  
  

Sentiments that the markets are going to be challenged by tough macroeconomic conditions have disappeared (well, almost!). A Bank of America July survey of fund managers shows that 68% of the surveyed managers expect the economy to experience a soft landing, with just 21% expecting a hard landing. The growing perception that we are headed for a soft landing is evident in the performance of some sectors. REITs, for instance, have performed well over the past three weeks and they are one of the sectors that had previously discounted Armageddon as the valuation of many of the companies fell to significant discounts to their stated net asset value.

The ECB is also expected to hike the deposit rate by 25bp to 3.75%. The early part of the week sees some data points that may affect the mood of policymakers. For ECB Chair Christine Lagarde, it may be a slightly more complex task of deciding whether the data warrants a rate hike at this meeting itself or in September. The outlook for the economy remains mired in a raft of conflicting signals. Industrial confidence was strong in April but weakened markedly in May/June without any key driver. This week’s industrial confidence surveys should show us whether the softness in the economy was just a pause or whether that softness will extend and see the economy experience some weak growth. Economists are generally of the view that a recovery in consumer confidence will help the euro area economy regain its poise. Last week’s consumer confidence data release showed an improvement, but, by historical standards, consumer confidence remains well below the long-term averages.

We remain underweight European equities. The eurozone will experience significant challenges ahead as it tries to align monetary policy with the general conditions of the economy. For example, this week sees the ECB raising rates at a time when Spanish consumer price inflation is likely to report a further fall to just 1.3% year-on-year and Italy producer price inflation at -4.3%. The challenge for the ECB is that German inflation for July is expected to rise to 7.1% while for France it’s estimated to increase to 5.2%. European corporate profit forecasts have drifted lower since mid-May, keeping the equity market in check.