Aurelia Butler

Good morning. We have an inflation report coming this morning and a Federal Reserve meeting and press conference on Wednesday, so it seemed like a good time for a somewhat more systematic look at the economy. We take one below. Email us: [email protected] & [email protected] news: Unhedged is going multimedia. Our new markets podcast, hosted by Ethan, features guests you know from the wider FT markets universe, including Rob, Katie Martin and Robin Wigglesworth. It debuts this afternoon. You can sign up here, or wherever you get your podcasts.Normalisation vs recessionThe economy is particularly hard to read right now, and has been so for a while. We have mostly been offering a “strong at the core, weak at the margins” read of it recently. Most other views out there fall into opposing camps. Some observers note the surprising strength of the economy, say recession is nowhere in sight, see inflation as sticky and bang on about higher rates for longer. Others think we are practically in a recession already and that deflation and rate cuts are right around the corner. Where on that spectrum are we?Back in early February, we wrote a piece called “The enigmatic economy”, presenting the indicators we looked at, and what they were saying, as follows (spot the typo):

What has happened since? Just about everything in the economy has slowed over the past four months. Very few indicators are strong in the sense that they show accelerating growth. The key distinction, therefore, is between two kinds of slowing. Some indicators are slowing gently and remain at or above historical averages, suggesting normalisation from unsustainably hot pandemic levels. Others are bouncing back from periods of sustained weakness. After 500bp of Fed rate tightening, these are signs of remarkable resilience. But still other indicators look like they are falling outright, in a way consistent with recession.So while we are sticking with a three-part schema, we have renamed the groups to reflect the fact that we are mostly making distinctions among flavours of deceleration:

Seen from on high, this is a picture of sturdiness. The economy is simmering down, but a bit at a time, rather than facing a vicious crunch. Employment, wages and spending are all still consistent with a return-to-normal story. Supporting all three is a remarkable run of expanding payrolls, an average monthly gain of 370,000 jobs since 2022. This has slowed to an average of 280,000 jobs over the past three months — still far above the 180,000 average monthly gains of the 2010-19 expansion.S&P 500 profits, which have shrunk 6 per cent since the peak a year ago, are 34 per cent higher than December 2019. That’s a 9 per cent annual growth rate, at the high end of the normal historical range. Even a few worrying soft spots such as housing and Big Tech earnings have levelled out a bit. Although services spending growth, as measured by ISM PMIs, has slowed for four months (and is now just shy of contraction), real services spending levels look consistent with normalisation, a return to something resembling pre-pandemic growth:Credit conditions, which we’ve called “mixed” above, look fine now but might get worse. Corporate credit spreads are surprisingly tight and the junk debt market is breathing new life. But the Fed’s senior loan officer survey, a forward-looking measure of credit conditions, looks bad. Bank lending to commercial and industrial businesses has also contracted for four months. Here’s C&I loans in year-over-year terms:If the economy is sturdy, what accounts for “faltering” stuff: the evident struggles of low-income consumers, weak real retail sales and a screeching slowdown in manufacturing and shipping? Pandemic imbalances and inequality. After every household bought an air fryer, two Peletons and a half-dozen game consoles during the pandemic, a goods recession was probably a fait accompli. Real goods spending is flat, but an inventory build-up combined with flat demand means the supply side has to shrink. Shipping, manufacturing and retail sales (which is growing slower than prices) are thus all stumbling. Here are US manufacturing ISM PMIs:Low-income consumers are struggling in an otherwise resilient economy because of the structural ugliness that is inequality. As we’ve written, a more equal income distribution would help growth, but it remains entirely (if regrettably) possible for most consumers to be spending merrily while the bottom quintile suffers.Unhedged, then, is firmly on the side of those who think recession is still a ways off, inflation is likely to stay above target for a while and rates will be higher for longer. That does not, however, mean we think the Fed should raise rates this week. The standard points apply: 500bp is a lot of tightening, and monetary policy works on a lag. We see little harm in raising rates more incrementally, say by staggering rate increases at every other meeting. The resilience of the US economy has surprised most everyone, us included. But it is slowing, and there is no need to keep using the monetary sledgehammer. A chisel might do.We could be wrong, and we will continue to scan the horizon for signs of recession. In particular, we will be waiting to see if falling profits cause job cuts. In principle, margin compression spurs companies to cut costs, especially facilities and jobs. So far, many dismissals have been concentrated in sectors that swelled during the pandemic. Any change in that pattern will be important. We’re also watching to see if the pain in the most vulnerable parts of the economy spreads. Will a rise in delinquencies for the bottom income decile, or defaults in the most leveraged decile of companies, spread to the next layer up? (Armstrong & Wu)One good readThe FT’s excellent Silvio Berlusconi obituary. More

The annual pace of US inflation eased last month to its lowest level in more than two years, but lingering price gains will keep pressure on the Federal Reserve to consider additional interest rate increases.The consumer price index climbed 4 per cent in May from a year earlier, a step down from the 4.9 per cent annual jump registered in April and marking the lowest increase since March 2021. On a monthly basis, consumer prices rose just 0.1 per cent, the data released by the Bureau of Labor Statistics on Tuesday showed.Once volatile items such as food and energy are stripped out, however, “core” CPI rose another 0.4 per cent in May — matching April’s increase. Compared to the same time last year, core prices are up 5.3 per cent.The latest read on inflation came just before the Fed begins its two-day policy gathering. The Federal Open Market Committee is widely expected to forego an interest rate increase this week after 10 consecutive moves since March 2022, but keep the door open to further tightening this year if warranted by the data.In a recent speech Fed governor Philip Jefferson backed the idea of a pause, saying it would give officials time to assess incoming data, the effects of the Fed’s rapid monetary tightening over the past 15 months, and the consequences of the recent turmoil in US regional banks.Moreover, Jefferson, who was elevated by the Biden administration to be the Fed’s next vice-chair, stressed that a pause in June “should not be interpreted to mean that we have reached the peak rate for this cycle”.Some officials have signalled they do not think the current level of the federal funds rate, which hovers between 5 per cent to 5.25 per cent, is high enough to damp demand to the degree necessary to tame one of the worst inflationary episodes to hobble the central bank in decades.

Fresh projections from individual officials about the fed funds rate, inflation, growth and unemployment are set to be released on Wednesday alongside the rate decision, and it is widely expected that policymakers will indicate at least one additional quarter-point rate rise this year is necessary.Economists recently polled by the Financial Times believe the Fed will eventually have to lift the benchmark rate to between 5.5 per cent to 6 per cent. That suggests at least two more quarter point rate rises this year.The respondents were chiefly concerned about inflation becoming entrenched and even more difficult to root out.Compared with the previous survey in March, the median estimate of the personal consumption expenditures price index once food and energy costs are stripped out — the Fed’s favoured inflation gauge — moved 0.2 percentage points higher to 4 per cent by year-end. As of April, it registered a 4.7 per cent annual pace, well above the Fed’s 2 per cent target. More

Manufacturers around the world are snapping up more European factories despite an economic downturn in the region, as geopolitical and supply chain concerns prompt businesses to bring their operations closer to their customers.Businesses acquired or leased 9.6mn square feet of industrial space in the region in 2022, a 29 per cent increase over the previous year, according to Cushman & Wakefield. The commercial property broker’s analysis covers transactions in nine European countries, including the UK, France and Germany.Tim Crighton, Cushman’s head of logistics and industrial in Europe, said he was recently seeing clients “nearshoring” by investing in European production so they are less dependent on China as well as other far-flung locations.Manufacturers from Asia to Europe were acquiring European factories in response to demand from clients in the continent, who in recent decades had outsourced the production of many of the goods they buy to China and other low-cost manufacturing hubs. The growing demand for new factories comes as overall take-up of European industrial space declines amid a fall in consumer spending which has prompted retailers and warehouse owners to cut back on investments.But companies are rethinking their strategy as tensions deepen between western governments and Beijing, as well as the severe disruption to global supply chains during the Covid-19 pandemic.Crighton said the use of robots in manufacturing, which has minimised the cost benefit of producing in regions with cheaper labour, created a “compelling” case for European businesses to boost production closer to consumers.Pointing to Mercedes-Benz’s recently announced plans to build its first factory dedicated to electric vans in Poland, as well as BMW’s plans to boost car battery production at a new plant in Hungary, Cushman’s report said central and eastern Europe, where labour was relatively cheap, had in particular seen “major investment in manufacturing”. Bert Hesselink, client relationship director at European commercial property owner CTP, said manufacturing sites were making up an increasing share of its portfolio since a drop-off in demand for warehouse space.“[Our clients] are being told, ‘if you want to continue supplying us, we prefer you do it from Europe instead of China’,” he added. Although investments in new sites were increasing manufacturers’ costs during a period of already heightened inflation, he said companies were prioritising securing their operations from the next supply chain “disaster”. Not all businesses were exiting China, however. Many have seen their supply chains affected by elevated energy costs, which recently helped tip industrial powerhouse Germany into a recession. In April, Dulux-owner Akzo Nobel said that the Dutch group was actually having to source more from China after energy costs forced its European suppliers to close factories.After years of western multinationals investing in China, business leaders have also warned that Europe lacked the manufacturing labour force to match. “It’s a challenge [finding people with the right skills],” said Hesselink. “And that needs to be dealt with by, for example, bringing in workers from foreign countries.” More

Bunzl, the UK distributor of products that range from plastic spoons to PPE, is “de-risking” its supply chain by shifting some of its sourcing from China amid geopolitical concerns in the Asia-Pacific.Frank van Zanten, chief executive, said that the company, which buys 10-15 per cent of the products it supplies to customers from China, was diversifying this sourcing into countries including Mexico, India, Vietnam and Malaysia.Bunzl’s customers range from hotels to supermarkets, including Walmart, its largest customer by revenue. “We import about $1bn [in products] from China,” said Van Zanten. “But . . . we are reducing our exposure in China by moving to other countries.”His comments come as tension rises between China and Taiwan — one of a number of issues dampening the investment appetite of European corporations. A slew of businesses are reducing their reliance on China as a manufacturing hub, moving to different parts of south-east Asia and other developing countries, while some are “onshoring” their supply chains closer to their home markets. “China is an important part of the world economy, so . . . I don’t think you can simply switch off China . . . but we are certainly de-risking,” added Van Zanten.He said concern around a potential invasion of Taiwan was “certainly one of the issues that a lot of businesses are looking at”. Other companies are also looking at contingent plans, with telecoms group BT holding “war games” in 2022 to prepare for a disruption from any conflict in the region.Bunzl’s supply chain solutions team is based in Shanghai and is responsible for auditing the group’s suppliers in Asia.“They are helping our companies to source, and they have visibility in all our [Asian markets including those] outside of China, so it’s getting very easy to move business from one supplier to [another],” said Van Zanten. The company has more than 10,000 suppliers around the world, but 75 per cent of the products it distributes are sourced in the countries where they are sold. North America accounted for just over 60 per cent of its sales in 2022. Its second-largest market is continental Europe.

Bunzl’s global supply chain gave the company a competitive advantage compared to its local competitors, said Van Zanten. This was “a key attraction” for the companies Bunzl acquired, he added.Acquisitions has been one of the engines of growth for the group, which reported adjusted pre-tax profits of £818mn on revenues of £12bn in 2022. It recently announced that it has made 200 acquisitions since 2004, partly funded by its performance at the height of the coronavirus pandemic when its orders of disposable gloves, masks and hand sanitisers soared.Marc van’t Sant, analyst at Citigroup, said Bunzl “traded very strongly through the pandemic because there was exceptional demand for a lot of their products”, adding that the company is “very cash generative” and the “M&A strategy has been largely self-funded”.However, he also warned that the economic backdrop has shifted. “Funding costs are now materially higher than they were pre-pandemic so . . . on an incremental basis it makes M&A less accretive than it was.” More

France is drumming up support for a global levy on greenhouse gas emissions from the shipping industry ahead of a summit hosted by Emmanuel Macron this month.Several people familiar with the discussions said France hopes to team up with other countries to issue a joint call for members of the United Nations’ International Maritime Organization to agree such a levy at its upcoming meeting in July. France is seeking to build a coalition of dozens of nations to back the idea, and has won support from Japan, Denmark, Kenya, Panama and Mexico — along with the Solomon and Marshall Islands, which have championed the idea for years — said one of the people familiar with the situation. If finalised, the call would be a key achievement to emerge from Macron’s summit for a new global financing pact, a two-day event the French president is co-hosting with the leader of Barbados on June 22-23 about climate finance and global financial reforms.A French diplomatic official said: “This is an initiative that some of our partners have been supporting for a long time, and this summit will give them an important political platform. It is undeniable that we will need new sources of income to finance the fight against climate change, which is why we will support this initiative.”The lobbying push comes ahead of an IMO meeting next month to discuss new targets for cutting emissions from the shipping industry. Shipping, which carries up to 90 per cent of global trade and largely relies on fossil fuels, is a major contributor to pollution but critics say it has been slow to decarbonise because of insufficient regulation.The maritime organisation has previously set a target for shipping to halve annual greenhouse gas emissions between 2008 and 2050, falling short of net zero ambitions in other industries.People present during previous talks said that industry lobbyists have opposed tougher measures, as have some member states with large shipping industries. Countries including Argentina, Saudi Arabia and China have been reluctant to support a levy, they say. The IMO typically makes decisions based on consensus among its members, but can also rely on a majority, said Tristan Smith, a shipping researcher at University College London. The EU already plans to introduce shipping into its emissions trading scheme, under which shipowners travelling through European waters will pay for their pollution. But an agreement on a greenhouse levy at next month’s IMO meeting would impose a financial cost on shipping emissions globally.If such a carbon levy was introduced, it would affect container shipping giants such as Switzerland’s MSC Mediterranean Shipping Company, Denmark’s AP Møller-Maersk, France’s CMA-CGM and their customers. However, it remains unclear what form a shipping levy would take. A proposal from the Solomon Islands and Marshall Islands, which are particularly exposed to rising sea levels, for a $100 a tonne emissions levy is considered the most developed, and has been discussed at working groups hosted by France ahead of the summit.Under the islands’ proposal, the money generated could be used to develop new fuels and help countries deal with the impact of climate change, among other uses.Last month a group of African nations said they would back a shipping levy used in part to help developing countries deal with climate change. But the French official said the planned announcement from the summit was unlikely to call for a specific level of levy or set out how the funds would be distributed. Such issues would have to be addressed later at the IMO.Aoife O’Leary, chief executive of non-profit Opportunity Green and an observer at the IMO, said it was “very likely” that a levy would be introduced because of growing support from countries, companies and trade bodies. But she added: “The question now is what is the levy and what is it used for?” More

The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset ManagementMarkets are prone to recency bias. They tend to assume what will happen in the future will mirror what has happened in the recent past. This year is a good example as investors are assuming that the global economy will revert to its pre-pandemic ways and keep trying to apply old rules of thumb.The narrative for much of the pre-pandemic period was that low growth drove low inflation, low inflation drove low interest rates, and low benchmark interest rates compressed credit costs that in turn drove up stock valuations, particularly for growth stocks such as technology companies.The markets have tried to run this trade numerous times over the past year. The US 10-year Treasury bond yield has pushed down towards 3 per cent on several occasions, before growth and inflation data pushed it back up. This has contributed to fluctuations in the valuation of growth stocks, which can be sensitive to changes in the benchmark bond yields that are used to discount the value of future earnings.Investors need to stop and acknowledge that the combination of the pandemic and Russia’s invasion of Ukraine has structurally changed the global economy.Inflation will be higher on average and more volatile. We have moved from a world of abundance to one of scarcity. The abundance of the past few decades stemmed in large part to several positive supply shocks. China’s entry into the World Trade Organization in 2001 brought vast numbers of relatively low-cost workers to the global supply chain. Considerable additional oil and gas mining in North America pushed down energy prices and reduced the ability of Opec to generate economic and inflation volatility. Globalisation kept inflation low and stable.The situation has changed. A shift in global supply chains and a race to electrify our economies, for both climate and energy security reasons, is likely to put continual pressure on goods prices for some time. Climate-related shocks are likely to generate bouts of cost pressures, not least through volatility in food prices.Furthermore, growth will be more evenly dispersed by sector and geography. This is because of the other meaningful change to have occurred during the past two years: governments’ approach to debt. The political narrative has shifted from austerity to “build back better”. This is a particularly notable change in Europe where fiscal austerity acted as a meaningful brake on activity for much of the past decade.Investors therefore need to adjust their mindset in at least three ways: first, the correlation between stocks and bonds will not be reliably negative in the way it was for much of the past two decades. Put simply, when inflation was absent, central banks only had to focus on growth. When the earnings outlook darkened, central banks reliably cut rates. This generated a consistently negative relationship between stocks falling and bond prices rising. Pairing stocks with bonds was enough for an all-weather portfolio. With inflation at least periodically back, this correlation will be unstable.As a result, investors need other tools for reliable diversification, and 2022 provides a good guide as to the options available, most of which are in private markets. Alternatives such as core infrastructure and timber offer the most reliable support to the value of a portfolio during an inflation shock.Second, with bond yields staying higher, the discount rate is back. One consequence is that investors should place more weight on the reality of near-term earnings, and less on the hopes of future profitability. Growth stocks are unlikely to benefit from the tailwinds of zero or negative discount rates. This leaves tech more vulnerable to potential earnings disappointment, particularly if artificial intelligence doesn’t prove to be the new economic miracle that seems to have been priced into some tech stocks today.Third, portfolios should be more regionally diversified across all assets. The past decade was characterised by “US exceptionalism” — in nominal growth, interest rates, stock performance and the currency. With Europe on a notably different fiscal and monetary path, I expect it to be less of an underperformer economically and in terms of asset market performance going forward.Investors have to stop relying on ideas that worked for the past decade. The world has changed and asset allocation decisions must follow. More