Market Synopsis – April 2024

Market Synopsis – April 2024

Apr 4, 2024 | 0 comments

For the first time in 17 years Japan raises rates

In 1991, the Bank of Japan (“BoJ”) started cutting interest rates in response to falling asset prices. They continued to do so until 1999. In the 25 years since then, Japan has maintained their near-zero interest rates, only raising rates once in 2007 for a brief period. Now, for the first time in 17 years, the BoJ has finally dismantled its package of extraordinarily accommodative measures that included negative interest rates – see Figure 1.

Figure 1 – An end to negative rates

On the 19th of March, the central bank announced a series of significant changes to their monetary policy. The first of which is lifting the target range on their main policy interest rate by +10bps to 0-0.1%, ending seven years of negative interest rates. The BoJ stated that they will also end their Yield Curve Control (“YCC”) program that capped the level of 10-year Japanese government bonds through BoJ purchases. Finally, they also intend to stop their purchases of ETFs and REITs and are looking to discontinue corporate bond buying within the next year.

So why is the BoJ hiking rates now?

Last month, Japan’s largest labour unions announced a 5.9% average wage increase at their annual Shunto wage negotiations. This represents the largest wage increase since 1993 and was shocking enough to prompt the BoJ to hike rates almost immediately after. However, there are other factors that led to the BoJ’s change in monetary policy too.

For example: Despite annual headline CPI inflation falling from a peak of 4.3% in January 2023 to 2.2% in January 2024, mainly due to falling energy prices, Japanese inflation still appears resilient. Core inflation remains at 3.5%, and services CPI inflation rose to 2.2% in January, a pace last seen in 1998. Service inflation poses further upside risk if the Shunto unionized wage shock is a sign of a broader nationwide acceleration in wages. This is quite possible given the exceptionally low unemployment rate in Japan, at just 2.4% in January.

In a jobs market this tight, it is quite likely that nationwide wage growth breaks out to new highs in the coming months, consistent with the Shunto wage increase. These higher-than-expected increases have added to the confidence among BoJ board members that the probability of achieving their long-held goal of a stable 2% inflation rate was “within sight”. After decades of deflation and stagnation.

As seen in Figure 2, the strong labour market and rising incomes have led to improving Japanese consumer sentiment. This, combined with the still-high levels of excess savings accumulated during the pandemic, should lead to a reacceleration of real consumer spending in the coming months.

Figure 2 – Japanese consumer confidence is rising

The BoJ will probably surprise with further hikes

At present, the Japanese overnight index swap (“OIS”) curve is discounting very little further tightening post the latest rate hike. In fact, the OIS curve forecasts policy rates rising to just 0.28% by the end of 2024 and 0.48% by the end of 2025. The expected path for rates, both in terms of level and the pace of hikes, may prove to be too shallow.

Why? The combination of rebounding Japanese economic activity, sticky inflation, and an economy that is running above potential is likely to lead to the BoJ proceeding with additional rate hikes over at least the next 6-12 months. The hikes are also likely to be at a faster pace than discounted by the present Japanese interest rate curve.

In the longer term, the BoJ will be limited in the total amount they can hike by what is still likely a low neutral interest rate as indicated in Figure 3 by R-Star, which is the short-term interest rate that would prevail when the economy is at full employment and stable inflation. The next few months will prove critical in observing how the Japanese economy responds to the additional BoJ rate hikes in order to determine if the neutral rate might actually be much higher.

Figure 3 – Japanese real rates are currently in easy territory

Given our outlook for the Japanese central bank’s policy we believe that the Japanese yen could represent an attractive opportunity for longer-term investors with a 3 to 5-year investment horizon. Both the purchasing power parity and the productivity model (Figure 4) suggest that the yen is one of the cheapest currencies globally, both in comparison to its peers and to its own history.

Figure 4 – Yen drawdown is at historic lows

A new dawn for Europe

The euro area has managed to just barely avoid entering a recession in 2023. Real GDP was unchanged in Q4 quarter-over-quarter and was up just 0.1% year-over-year. Germany was one of the worst performing economies as GDP shrank 0.2% year-over-year in Q4 2023. France, Italy, and Spain managed to fair a little better as GDP rose 0.7%, 0.6% and 2%, respectively. Euro area growth should marginally improve over the next few quarters as the global manufacturing cycle stabilises. Korean exports tend to lead the euro area manufacturing PMI, and these have been rising in recent months. In addition, the new orders-to-inventory component of the Swedish manufacturing PMI has moved back above zero – see Figure 5. It also typically leads euro area manufacturing PMI.

Figure 5 – European manufacturing should pick up

While euro area inflation surprised on the upside in February, it remains well below its recent highs. Falling inflation has allowed real wages to start growing again, which has bolstered consumer confidence. Unlike in the US, European households still have significant excess pandemic savings (Figure 6, Panel 1), which they may choose to deploy as consumer confidence returns. Looking at consumer demand for durable goods in Figure 6 Panel 2, it remains robust and may even pick up from here. For example, vehicle registrations are still 30% below 2019 levels yet climbing – see Figure 6 Panel 3.

Figure 6 – Pent-up consumer demand in Europe

The looming credit squeeze

Despite these positive developments, significant risks remain. The European Central Bank’s (“ECB”) latest Bank Lending Survey showed that banks continue to remain cautious, tightening their lending standards in Q4 2023, albeit at a slower pace than in prior quarters. In addition, the money supply is shrinking while the bank credit impulse (the change in new credit issued as a percentage of GDP) remains deep in negative territory – see Figure 7. These are markers of a tight monetary environment and are not conducive to economic growth.

Figure 7 – Tighter rates are slowing the European economy

The ECB forebodingly predicts that 30% of household loans will reset to higher rates in the next 12 months. For example, in Spain and Italy, as much as two-thirds of loans will be repriced. As a result, one can expect the interest burden on households to increase meaningfully. Finally, European fiscal policy is set to become more restrictive too. The IMF estimates that the euro area will face a fiscal drag of 1% of GDP in 2024 as nations like Germany are blocked by their Constitutional Court from spending residual pandemic funds.

A false dawn for Europe

Up until now, European labour markets have remained relatively strong. Despite minimal GDP growth, employment in the euro area managed to rise 0.6% in 2023. While unemployment improved, down from 6.6% in January 2023 to 6.4% in January 2024.

However, beneath the surface, labour demand appears to be weakening. According to Eurostat, the job vacancy rate fell from 3.1% in Q4 2022 to 2.7% in Q4 2023. Indeed, a large job postings site, reports that job openings continue to dry up, down 28% from the peak in late 2022 – see Figure 8. The situation is much the same in the UK, with the Office for National Statistics estimating that job openings are also down 30% from their mid-2022 peak. Thus, the labour market in Europe and the UK appears not dissimilar to the US and will likely crack towards the end of this year.

Figure 8 – Job openings are declining

As a result of the resilience of European consumer demand, we believe that euro area will continue to rebound in the coming months, however towards the end of 2024 as households are saddled with an increased debt burden and a materially weaker job market, it is quite likely that the region will be pushed into a recession.

Investment takeaways

While the macroeconomic picture in the US continues to develop in line with our expectations, we took the opportunity to instead turn our focus to the unfolding events in the Japanese and European economies this month. The recent developments in Japan, which have prompted the BoJ to implement extraordinary measures and hike rates after an almost 25 year ultra-accommodative cycle mean that Japan is an important economy to watch as it navigates this transition period. Meanwhile, the euro area, which on the surface appears more robust than the US, will likely succumb to a similar fate as cooling labour markets eventually drag the economy into a recession.

If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, connect with Integrity Asset Management and let us help you navigate your investing journey.

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Source: Bloomberg, 28 March 2024