Following the exceptionally strong performance in July, equity markets were more benign in August. A continuation of the rally in the first half of the month was paired, leaving major indices little moved in the month. Given the backdrop of risks, which in some cases have heightened, it is notable that markets have rallied as far as they have and that the gains from July have been retained. Investors continue to be buffeted by current high inflation and tightening monetary policy, as well as the prospect of an imminent recession. While both scenarios are not positive for risk assets, a recession or economic slowdown would likely cause both inflation and interest rates to ease, alleviating the major headwinds that have been seen this year. However, the damage to demand and margins caused by a recession should also not being overlooked.
Similarly, bond markets remain volatile, as a similar dilemma is present. Short term yields continue to rise as traders price in higher interest rates, however, medium to long dated bonds see investors attempting to anticipate the magnitude and duration of the current tightening cycle, as well as the longer term prospects for growth. This has led to sharp moves in within fixed income, something broader financial markets are now accustomed to.
Anticipating monetary policy continues to be a primary focus of markets, and although interest rate rises have been broadly been implemented as predicted, expectations remain fluid. US interest rate expectations appear to have plateaued, with inflation rolling over and a recession increasingly likely. The changing picture in the UK has been more notable. With short term inflation expectations being revised higher almost daily, and the Bank of England taking a firming stance on price stability, UK interest rates are now expected to reach 4%.
Some respite came towards the end of the month, with UK wholesale gas prices falling over 20% on 30th August, as progress with filling gas reserves in Europe was ahead of schedule. However, such was the run up in prices, they remain higher than they were at the beginning of the month. Gas prices remain the main driver of domestic inflation, impacting electricity prices, inputs and business costs. Second round effects are now being seen with wage settlements increasing and strike action brought on by the cost of living crisis becoming a common occurrence. This reinforces the Bank of England’s conviction over higher interest rates. Such is their desire to suppress inflation, that it is likely they are willing to cause a recession to do so.