There is a growth convergence story in Europe vs the US. Fed hikes are materially slowing the US economy. Meanwhile, in Europe the combination of fiscal stimulus and dramatically lower energy prices have shifted the growth negative headwind of last year into a tailwind for early 2023. European growth is still likely to be weak, but not as dramatically as was priced at the end of last year.
US CPI inflation might slowdown dramatically in the months ahead: From an energy and goods price inflation point of view, the risk later this year is probably deflation, not inflation. ISM manufacturing output prices have collapsed to -1.5 standard deviations and several other surveys suggest similar declines too.
Europe is much more exposed to a China reopening than the US: Leading indicators such as China’s credit impulse suggest EUR strength ahead, even before the latest reopening news. But looking ahead the euro area stands to gain much more from a boost in China’s growth outlook than the US, both from the trade angle (exports to China are roughly 2.7% of German GDP vs 0.7% of US GDP) and the potential for tourism flows into Europe too.
Why peak inflation is turning into rapid disinflation, USD weakness and EUR upside
US growth to continue slowing, while European rebounds
China’s reopening to have a big impact on European data
Several leading indicators for US inflation point to large falls ahead
TIght UK jobs market showing signs of slowing
The jobs market remains very tight, and the signs of slowing that are creeping in look insufficient to bring the pace of wage growth down in a timely fashion. Wages continued to rise apace in today’s report, running at around 7% annualised on the average weekly earnings measure.
The unemployment rate failed to rise today and at 3.7% remains only modestly above its recent low point. Vacancies are falling, but at the rate they are doing so would take over a year to get back down to their pre-pandemic level.
The fallout on the labour market from a weaker economy might prove more limited than we (and especially the Bank of England – which in November expected around a 6.5% peak in the unemployment rate) expect. A more resilient, but slowing, labour market, alongside strong earnings growth suggests the need for further monetary policy action, and we see the Bank raising rates by 50bp in February and 25bp in March for a peak of 4.25%
Trading GBP in 2023
As it is over six years since the UK EU referendum took place it has become all too easy to say “we expect GBP to underperform due to Brexit” and ignore other factors that matter much more for trading it month to month, such as global risk sentiment, energy prices or the latest decisions by the BoE (perhaps more importantly the Fed).
If the USD broadly sells off it would be difficult for GBP/USD not to rise with it. This is why we believe GBP/USD may rise towards 1.25 by the end of the month, with the move we expect in EUR/USD (to 1.10).
But in relative value crosses, such as EUR/GBP or GBP/CHF, this is where most investors tend to express their bearish UK view. This has been a part of the problem, short GBP vs peers is too much of a consensus trade for us to put capital to work in it. However, if the story of 2023 is a continued rise in EGB yields, EUR/GBP may continue to slowly grind higher, but for GBP/USD we suspect the path of least resistance is higher (thanks to a global risk sentiment rebound), with 1.32 for GBP/USD by year-end in our view.
Central banks play chicken with financial markets
In the euro area, the focus will be on January surveys for firms (PMIs, Ifo, Insee, Istat) and consumer confidence surveys, where we expect continued improvement. Otherwise, there is also German retail sales and ECB M3 data, both of which we foresee weakening, and finally we have Spanish unemployment data and the first estimate of Spanish Q4 GDP growth, and believe Spain may have narrowly avoided entering a recession.
In the UK, we have a mix of hard and soft data. On the official side the ONS releases its long-awaited producer prices report for November and December, having been postponed due to errors in calculation (which have now been corrected). Budget deficit figures are also due.
On the survey side we have the PMIs (we see a small rise to take the composite index to within half a point of the 50-no change level) and both the CBI industrial trends survey (including the quarterly balances) and its retail sales counterpart.