This “back to school” week always makes us think about new beginnings and how we can improve our trading and understanding of financial markets. Thus, this week we think that it’s worth focusing on the key drivers of markets over the coming months. Some of them may challenge the current orthodoxy on key market ideas, but it’s always worth looking at things from various angles, in our view, and when it comes to trading, don’t rule anything out.

1, Is the Fed too hawkish?

The Fed is staying hawkish even though US inflation is falling. For example, the headline rate of inflation fell in July, and there are signs that there could be steeper declines in August. For example, US gas prices have declined sharply, and retail gas (petrol) prices are now back at February 2022 levels. Added to this, food prices are also deteriorating. The FAO world food price index fell in August, registering its fifth monthly decline. All the five food components that make up the index fell, with a monthly decline of 1.4% for cereals and 3.3% for vegetable oils. The FAO food price index is still 7.9% above its level from last year, however, it is moving in the right direction.

Chart 1: FAO food price index:

Source: FAO

The decline in food commodity prices will show up in grocery prices, although this usually happens with a lag. Thus, Thanksgiving dinner in the US, may not be as expensive as some fear if this trend in food commodity prices continues. The ISM manufacturing prices paid index also fell sharply in August, as you can see below. This is worth watching, as the ISM surveys tend to be a lead indicator for overall economic activity.

Chart 2: ISM manufacturing prices paid index

Source: FX Street

This leads to the question, why is the Fed still sticking to its hawkish mantra, if prices are showing signs of declining and headline and core inflation could turn lower in the coming months? There are two reasons for this in our view: firstly, the outlook remains uncertain and these declines in key commodity prices could prove transitory. Secondly, the Fed might be wary of acknowledging the decline in key inflation indicators too soon in case the markets convert it into animal spirits, leading to another surge in price rises. Thus, the Fed is likely to stay hawkish and continue hiking interest rates, to ensure that price pressures are well and truly contained. However, this could come with a high price tag: weakening economic growth.

2, The US labour market

A few months ago, there were some labour market indicators in the US that looked like they might be turning lower, however, data in August, suggests to us that the US labour market is strong, and in some areas, it is improving. While there has been some decline in sentiment indices of employment, for example, ISM employment indices, Empire State manufacturing employment index and the Household Employment Survey, we are starting to see these as an anomaly, with huge strength in the unemployment rate, the labour force participation rate, which is also pointing to a healthy labour market, initial jobless claims, continuing claims, Challenger jobs layoffs and, of course, the NFP report. Last Friday’s NFP report showed that the US economy created 315k jobs, higher than the 300k expected. Although this is weaker than the 526k jobs created in July, it is still well above average and suggests that the US labour market remains on fire. Due to this, the US labour market looks incredibly strong, and there are no real signs that the labour market is slowing down. What does this mean? The Fed is unlikely to pivot anytime soon, and they will remain wary about slowing down their pace of rate hikes when one of the key fundamental pillars of the US economy remains so strong.

3, Ex-US Growth

China and Europe are the areas that we are most worried about when it comes to growth. Analysts are already slashing their growth outlooks for China due to ongoing lockdowns and the Covid zero strategy, along with the collapse of the real estate market. In the Eurozone, the ECB increasingly has no choice but to hike rates, and to hike them aggressively. Read our ECB forecast for more information, that will be released later this week. However, service sector inflation is at its highest level for more than 20 years, credit spreads are widening and there is the massive energy crisis that is looming after Russia cut off natural gas supply to the Nordstrom pipeline. The ECB must raise interest rates, even though Italian elections are coming up, and this will be a chilling winter for Europe. Thus, we are at some critical junctures: 1, for the global economy, and 2, the real risk of an existential crisis for the Eurozone, that could reach a peak in the coming months.

4, The market impact

Right now, the prevailing theme is that the US economy is strong, and the Fed will continue with bumper rate hikes for the foreseeable future, even if there are signs that inflation is slowing down. From a market perspective, that is positive for the dollar for the rest of this year. The US dollar index is at its highest level since 2002, and it is likely to remain this way for some time. The dollar index has hesitated at 110, however, momentum indicators are still strong, and this index is likely to make further highs in the coming months.

Stock markets have lost their mojo after the summer recovery rally. The S&P 500 reversed gains on Friday and experienced a third straight week of declines. This is to be expected, growth is slowing in the major economies, and interest rates are moving higher in the US and Europe. This macro turmoil is playing out in the stock market, and there could be further to go. Earnings season for Q3, which will kick off in October, is worth watching closely. This could be when we see earnings show signs of weakness, after they were propped up by the energy sector in Q2. It’s also worth noting that investors tend to wait to see a weakening in earnings growth before they take money out of the stock market. Thus, the nadir for stock markets may not come until Q4.

Key themes as we move into September