The Long-Awaited Merge

This week was certainly a busy one. New data showed the UK economy grew by less than expected in July while unemployment fell to its lowest level since the 1970s. Over in the US, all eyes were on August’s inflation report which came out on Tuesday, and the worse-than-expected data wreaked havoc on markets. In Europe, meanwhile, investors are bailing out of stock funds in droves as the region’s list of problems grows by the day. But at least European natural gas and power prices slumped at the start of the week as the EU outlined details of its market intervention to deal with the unprecedented energy crisis. Finally, the long-awaited Ethereum “Merge” went live on Thursday – here’s what it means.

Macro

New data out on Monday showed the UK economy grew by 0.2% in July compared to the month before – a slower recovery than expected from June’s 0.6% slump, which largely reflected the loss of two working days that month linked to Queen Elizabeth II’s jubilee celebration. While the services sector expanded in July, industrial production and construction both shrank for the second consecutive month. All in all, that means the size of the UK economy in July was the same as it was six months ago.

The poor start to the third quarter, combined with another bank holiday for the Queen’s funeral on the 19th of September, may be enough to tip the economy into recession this quarter. After all, consumers and businesses are still struggling under the weight of soaring inflation and higher energy bills. And that’s even with the new prime minister’s package of measures to freeze further increases in electricity and gas bills, which won’t be in effect until October.

Compounding the inflation issue is the UK’s tight labor market: new data out this week showed the country’s unemployment rate fell to 3.6% in the three months to July – the lowest level since 1974 – as more people dropped out of the workforce. That labor market tightness is creating upward pressure on wages and could lead to even further inflation because of the “wage-price spiral”. This is where higher wages lead to increased spending and higher inflation. Rising prices of goods and services, in turn, push employees to demand even higher wages. This only gets worse as companies raise the prices of their products to offset higher wage costs. This loop leads to higher and higher (i.e. spiraling) inflation.

Over in the US, all eyes were on August’s inflation report, which came out on Tuesday and wreaked havoc on markets. Consumer prices increased 8.3% last month compared to the same time last year. While that marked a slight slowdown from July’s 8.5%, it was higher than the 8.1% economists were expecting and is still near a four-decade high. Making matters worse, consumer prices increased 0.1% on a month-on-month basis, defying expectations for a 0.1% drop. Meanwhile, core consumer prices (which strip out volatile energy and food components) advanced 0.6% from July and 6.3% from a year ago. Both these figures topped forecasts, with the year-on-year core inflation accelerating for the first time in six months.

The rise in core inflation confirms the very sticky nature of the US inflation problem, and will keep up the pressure on the Fed to continue aggressively hiking interest rates – especially considering that this is the last major data release before the Fed’s next meeting. In fact, right after the inflation figures, traders moved to fully price in another jumbo rate hike of 75 basis points at the Fed’s upcoming meeting next week. That prospect of further aggressive rate increases (or, depending on how you look at it, the diminishing prospect of a “Fed pivot”) sent stocks tumbling on Tuesday, with the S&P 500 closing down 4.3% – its worst single-day performance since June 2020. Bond yields and the dollar surged.

Stocks

Europe’s list of problems seems to be growing by the day: a war with no end in sight, still-soaring inflation, an energy crisis that could result in rationing this winter, slowing economic growth, a central bank that’s started to aggressively hike interest rates, and a common currency that’s slumped to a 20-year low relative to the dollar. How the region will overcome all these issues is anyone’s guess, but investors aren’t lingering around to find out: according to Deutsche Bank, investors have pulled almost $100 billion from European stock funds in the past 12 months – way more than from any other major region.

Europe’s problems are only getting worse, with the escalating energy crisis threatening to tip the region into recession. In fact, forecasts among economists for a recession in the eurozone over the next year have climbed each month in 2022, with odds reaching 60% in August, according to Bloomberg. If the predictions prove to be correct, the economic slump would further dent European firms’ profits, which is why Citigroup is expecting a slew of downgrades to earnings forecasts in the next few months, while Morgan Stanley is warning that profit margins face the biggest decline in more than a decade. With such pessimistic forecasts, it’s no wonder investors have been fleeing European stocks in droves.

All in all, strategists at investment banks reckon the recent rally in European stocks has run its course. The Stoxx Europe 600 Index will end 2022 at 447 points, implying gains of around 5% from here on, according to the average of 15 estimates in Bloomberg’s latest monthly survey. That means the key European stock benchmark is seen falling 8% for the year, which would mark its worst annual performance since 2018.

Commodities

Natural gas and power prices slumped in Europe at the start of the week as the EU outlined details of its market intervention to deal with the unprecedented energy crisis, including a proposal for mandatory targets to reduce electricity demand. The EU is seeking to lower power consumption and provide liquidity to energy markets in a bid to prevent the crisis from consuming the broader economy. The proposals also aim to cap excessive revenues of companies producing power from sources other than natural gas.

Still, even after this week’s moves, prices remain almost eight times higher than normal for this time of the year. But at least someone expects the situation to improve: Goldman Sachs is predicting energy prices to halve from current levels in the first quarter of 2023. That’s partly because European gas storage sites are about 84% full – slightly above the five-year average. Helping matters is that the region is adding more facilities to import liquefied natural gas (LNG) to compensate for lost supplies from Russia, with the latest LNG terminal opening last week in the Netherlands. All in all, Goldman expects LNG imports to be up 16% versus last winter.

Crypto

Ethereum completed a long-awaited upgrade to its blockchain network in the early hours of Thursday. The revamp, known as the “Merge”, will make Ethereum a lot more energy efficient (consuming around 99% less electricity) and should, over time, pave the way for it to scale up and become much quicker. But while the network's developers say the update, which was years in the making, will go smoothly, some investors are wary of possible hiccups. Watch this space.

Next week

A few US companies are reporting earnings next week, including Accenture, Costco, and FedEx. The economic calendar is dominated by central bank meetings by the Bank of England, Bank of Japan, and the Federal Reserve. The last is expected to deliver another “jumbo” rate hike of 75 basis points for its third meeting in a row after Tuesday’s terrible inflation report. Elsewhere, we have PMI data coming out of the eurozone and UK on Friday. Note that Monday the 19th of September is a bank holiday in the UK for the Queens’ funeral.