Could UK inflation reach double digits?

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Head of AIS Portfolio & Business Consulting, Sophie Antal-Gilbert, discussed the latest inflation numbers from Canada and the UK. They also chatted about June PMI (purchasing managers' index) data from the U.S. and UK, as well as the recent decline in the U.S. 2-year government bond yield.

Consumer prices tick up again in the UK and Canada

Antal-Gilbert and Lin opened the conversation by noting that inflation continues to surge in Canada, with May's consumer price index (CPI) climbing 7.7% on a year-over-year basis-up from an already-high reading of 6.8% in April. The energy sector was a key driver behind the increase, Lin noted, with energy prices skyrocketing by nearly 35% in May on an annual basis.

He added that even when volatile items like food and energy were stripped out, the CPI median measure-one of the key inflation gauges used by the Bank of Canada (BoC)-still rose at a rate of 4.9% in May on a year-over-year basis, versus 4.6% in April. "The May numbers show that inflation is not only increasing, but broadening out across the Canadian economy," Lin remarked. In his opinion, the uptick in pricing pressures means that the BoC will likely hike interest rates by 75 basis points (bps) at its July meeting, following a 50-bps increase earlier this month.

Turning to the UK, Lin said that consumer prices rose 9.1% in May on a year-over-year basis, which marked a 0.1% increase from April's elevated reading of 9.0%. "On the surface, a 0.1% increase may not sound like much, but the key takeaway here is that at 9.1%, the UK has the highest inflation rate of all G7 (Group of Seven) countries," he stated. In addition, the Bank of England (BoE) is now projecting that the country's inflation rate could reach as high as 11% later this year, Lin added.

All in all, the latest numbers from the UK and Canada are likely to place even more pressure on central banks to increase borrowing costs in order to bring inflation under control, he said. However, at the same time, Lin noted that central banks need to keep a watchful eye on the state of the economy in order to prevent tightening monetary policy too aggressively-specifically, to the point where it could tip the economy into a recession. "Central banks today have a tight balancing act to navigate in order to pull off a so-called soft landing-where economic growth slows, but a recession is avoided," he concluded.

June PMI surveys point to potential slowdown in growth

Turning to the latest economic data releases, Lin noted that in the U.S., the S&P Global composite PMI survey dropped to a level of 51.2 in June. A reading above 50 indicates expansionary conditions, while a reading below 50 points to contractionary conditions, he said. "This means that overall, U.S. economic activity is still increasing, but at a slower rate," Lin explained.

Zooming in on U.S. manufacturing, he noted that the manufacturing output index slipped into contractionary territory in June, with a reading of 49.6. The number mirrors earlier data points from the Philadelphia Fed manufacturing index, Lin said, which also pointed to weakness in U.S. manufacturing.

He added that a similar story is playing out in Europe, with the rate of growth in UK manufacturing declining from May to June, while the S&P Global Eurozone composite PMI slipped to a 16-month-low reading of 51.9. Eurozone manufacturing activity also weakened during June, Lin said. "Overall, these numbers show that perhaps some signs of an economic slowdown are starting to emerge," he stated.

With central banks around the globe continuing to raise rates, markets will be paying extra-close attention to economic indicators like the PMI surveys, Lin said. "Higher rates will have the effect of moderating demand-and a little moderation is a good thing, as it would bring supply and demand levels back into balance. But if this moderation in demand comes too quickly, we'll likely see potential recession risks increase," he stated.

Economic concerns fuel decline in 2-year U.S. Treasury yield

Antal-Gilbert and Lin wrapped up the segment with a look at recent movements in the U.S. 2-year Treasury yield. Lin said that on 23 June, the 2-year yield dipped to as low as 2.87%-a significant drop from earlier this month, when it hovered around 3.4%. Part of the decline can be attributed to increasing investor concern over a slowdown in economic growth, due to the weakness shown in the latest PMI surveys, Lin noted. He added that a drop in bond yields is actually good news for bond investors, as it increases the value of a bond.

"Overall, investors are starting to become more worried over whether or not the Fed can engineer a soft landing," Lin stated. In the short-term, markets are still pricing in another 75-basis-point rate hike at the central bank's July meeting, but over the next 12 months, expectations for the cash rate have been lowered, he noted. "On 22 June, investors were anticipating that the federal funds rate would stand at around 3.78% in March 2023. The next day, in the wake of rising concerns over the economy and the potential for Fed overtightening, markets lowered their expectation for the cash rate to 3.46%," Lin explained.

Lin concluded by stating that he doesn't see a U.S. recession as inevitable, as he believes there's still a chance that the Fed can pull off a soft-or soft-ish-landing. However, it's important for investors to be aware of the risks of an economic downturn, he said. "Ultimately, I believe discipline during these times of uncertainty - in other words, sticking to a strategic asset allocation-  will be critical in helping investors achieve their long-term goals," he stated.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.