U.S.

Equity markets surrendered early gains as investors seemed to grow increasingly concerned that the Federal Reserve would accept a recession as a price for taming inflation. Large-cap growth stocks bore the brunt of the selling, causing the technology-heavy Nasdaq Composite Index to underperform. As indicated by Russell indexes, however, small-cap growth stocks were the best-performing equity category for the month. T. Rowe Price traders noted that market volatility was accentuated by thin summer trading volumes.

Bond prices also suffered as the yield on the benchmark 10-year U.S. Treasury note hit its highest level since late June; the yield on the two-year note hit its highest level since 2007. (Bond prices and yields move in opposite directions.) Fed Chair Jerome Powell and other policymakers stressed that they would not hesitate to raise interest rates, even if it brought an economic slowdown. According to T. Rowe Price U.S. Economist Blerina Uruçi, Powell’s comments at the Fed’s annual Jackson Hole gathering in late August were “resolutely hawkish” and confirmed that he perceives taming inflation as the bedrock of the recovery.

August Starts on Hopeful Growth and Inflation Signals…

The month started out on a hopeful note on both the growth and inflation fronts. The Labor Department reported that employers had added 528,000 nonfarm jobs in July, more than double consensus expectations of around 250,000, while May and June estimates were revised upward. The unemployment rate fell to 3.5%, matching its February 2020 level. Service sector activity accelerated unexpectedly in July, while retail sales also proved more resilient than expected. 

The best news for investors may have been that the growth came with moderating inflation, raising hopes that the Fed would be able to achieve a “soft landing.” Headline consumer prices stayed steady in July, and the year-over-year increase fell back to 8.5% from June’s reading of 9.1%. The year-over-year increase in the producer price index fell from 11.3% in June to 9.8% in July, registering the first pullback in the headline number since April 2020. The University of Michigan’s consumer sentiment index rose by more than expected in August, as consumer inflation expectations over the next year moderated to 4.8% (according to revised data), the lowest level since last December.

…But Rate and Recession Worries Resurface at Mid-Month

Fears that “peak inflation” may prove illusory drove markets lower in the second half of the month, however. On August 18, St. Louis Fed President James Bullard told an interviewer that a peak was “not statistically really in the data at this point” and indicated that he would probably vote to increase the federal funds target rate by another 75 basis points at the September policy meeting. August ended with futures markets placing a 69% chance on such a move, according to CME Group data, and markets were also pricing in a reasonable (31.9%) chance that the fed funds target rate would move as high as 4.00% to 4.25% by March 2023—well above its current range of 2.25% to 2.50%. 

The tone of economic data arguably darkened as well. Personal income and spending for July missed expectations, rising a meager 0.2% and 0.1% over the month, respectively. The savings rate was unchanged at 5% of personal disposable income, less than the pre-pandemic trend, indicating that consumers are reaching into savings to maintain spending. The housing sector continued to struggle under the weight of higher mortgage rates, and existing home sales fell back to their lowest level since May 2020. Rising tensions between China and Taiwan may have also played a role in the market’s late retreat. 

Europe

In local currency terms, the pan-European STOXX Europe 600 Index ended sharply lower as fears intensified that energy rationing and the efforts of key central banks to subdue inflation could deepen an economic downturn. Major indexes in Germany, Italy, France, and the UK also dropped.

Surging energy costs also weighed on markets, as Russia halted already curtailed natural gas exports to Europe at the end of August. The euro also sank to below parity with the U.S. dollar.

ECB Policymakers Call for Big Rate Hike 

Eurozone money markets were pricing in a roughly 80% chance of an exceptionally large 0.75 percentage point rate hike by the European Central Bank (ECB) at its September meeting, after a chorus of hawkish comments by policymakers and data showing record inflation. Executive Board member Isabel Schnabel said at the Jackson Hole conference that central banks should act “forcefully” to reduce high inflation, even at the risk of lower growth and higher unemployment to minimize the risk of bad economic outcomes. Banque de France Governor François Villeroy de Galhau said that policy would need to remain tight for an extended period and that he favored “another significant step in September.” German Bundesbank President Joachim Nagel said the bank should again act decisively to subdue inflation, indicating that they favored another large increase as well. However, ECB Chief Economist Philip Lane argued at a conference in Barcelona that borrowing costs should increase at a “steady pace” to allow for any downward adjustment in inflation forecasts. 

Sharp Eurozone Slowdown Looms Amid Record-High Inflation and Low Unemployment

Inflation in the euro area accelerated more than expected to a record 9.1% in August, up from 8.9% in July. Surging energy and food prices were the primary drivers. The number of jobless people in the bloc dropped by 77,000 in July, leaving the unemployment rate at a record-low 6.6%, Eurostat said. 

Eurozone business activity shrank for a second consecutive month in August, another sign of a possible recession in the third quarter, according to purchasing managers’ surveys. An early reading showed that S&P Global’s Composite Purchasing Managers’ Index (PMI) fell to an 18-month low of 49.2 in August from 49.9 in July. (PMI readings less than 50 signal a contraction.) Activity in the services industry almost stalled as consumers cut spending, while manufacturing activity contracted due to supply constraints. 

BoE Raises Interest Rates, Inflation Forecast

In the UK, the Bank of England (BoE) raised its key interest rate by 50 basis points (0.50 percentage point) to 1.75%, the biggest increase in 27 years. It also projected that inflation would hit 13.3% by October because of surging energy prices. The BoE expects inflation to remain “very elevated” through 2023 and to recede in two years’ time to its 2% target. It forecast that a recession lasting five quarters would begin this winter. 

Gazprom Extends Nord Stream 1 Pipeline Closure Indefinitely

Russia’s state-owned energy company Gazprom initially closed the Nord Stream 1 natural gas pipeline to Germany for three days of maintenance at the end of the month but then extended the closure indefinitely. Meanwhile, Gazprom said it would further reduce deliveries to French utility Engie due to a disagreement over contracts. Storage levels of natural gas for winter had reached 90% of their capacity in France and more than 80% in Germany, officials said.

Japan

Japanese stocks rose in August, with the MSCI Japan Index gaining 1.08% in local currency terms. A primary driver of global equity investor sentiment during the month was the anticipation that the U.S. Federal Reserve would be less aggressive with its interest rate hikes, only for the central bank to signal a more hawkish outlook by the end of the period, leading to renewed concerns about an economic slowdown.

Japan’s export-oriented firms continued to benefit from a weak yen, which fell to around JPY 138.9 against the U.S. dollar, from about 133.2 at the end of July. The Japanese currency is hovering at 24-year lows on expectations of continued monetary policy divergence between the Fed and the Bank of Japan (BoJ), which remains committed to maintaining ultralow rates. The yield on the 10-year Japanese government bond rose to about 0.22%, from 0.18% at prior month-end, amid a global bond sell-off.

Economic Data Remain Mixed

Japan’s gross domestic product expanded by an annualized 2.2% in the second quarter of 2022, according to the Cabinet Office’s preliminary reading. This missed consensus expectations of around 2.5% growth, however. More positively, Japan’s industrial production rose by more than anticipated in June, according to the Ministry of Economy, Trade, and Industry. Industrial production increased by a seasonally adjusted 9.2%, surpassing initial expectations of 8.9%.

Meanwhile, inflation in Japan remained above the BoJ’s 2% target, influenced by higher fuel prices and a weaker yen. Excluding fresh food, core inflation increased to 2.4% year on year in July from 2.2% the previous month. This was in line with consensus expectations. Core inflation has now exceeded the central bank’s 2% target for four consecutive months.

Cabinet Reshuffle Signals Policy Continuity

Prime Minister Fumio Kishida reshuffled his cabinet in early August following the Liberal Democratic Party’s (LDP’s) convincing win with its coalition partner Komeito in the parliamentary upper house election on July 10. He signaled policy continuity by retaining top figures in key posts, including Finance Minister Shunichi Suzuki, Chief Cabinet Secretary Hirokazu Matsuno, and Foreign Minister Yoshimasa Hayashi. Some of the top economy-related posts were given to LDP lawmakers who had close ties to former Prime Minister Shinzo Abe, who was assassinated on July 8 while campaigning for the election, suggesting that the basic tenets of his signature economic policy, “Abenomics,” built on the three pillars of monetary easing, fiscal stimulus, and structural reforms, are likely to be retained.

Rethinking Policy on Nuclear Power

Securing stable energy supplies at reasonable prices is a prerequisite for shifting Japan’s economy into green transformation, or GX, a key tenet of the government’s “New Capitalism” agenda, which includes a commitment to achieve carbon neutrality by 2050. In a major announcement, Kishida said that the government will look at the development and construction of next-generation nuclear power plants—this would mark a significant shift in energy policy as most of Japan’s nuclear power plants have remained offline after the 2011 Fukushima nuclear disaster. The government will also restart more idled plants and consider extending the lifespan of existing reactors.

China

Chinese stock markets fell as coronavirus lockdowns, travel restrictions, and weak economic data sapped risk appetite. The broad, capitalization-weighted Shanghai Composite Index declined 1.6% and the blue chip CSI 300 Index, which tracks the largest listed companies in Shanghai and Shenzhen, fell 2.2%. The MSCI China Index, which includes overseas listings, added 0.23% after China and the U.S. resolved a long-standing dispute over the auditing of U.S.-listed Chinese firms. The yuan weakened 2.27% versus the U.S. dollar as growth worries intensified.

Heatwaves Add to COVID Disruptions

Heat-induced disruptions have added to the headwinds facing China’s economy. Provinces including Chongqing and Sichuan are struggling after heat waves caused crop damage, forest fires, and power (GDP) rationing. China’s gross domestic product narrowly avoided contracting in the second quarter amid widespread virus lockdowns and a nationwide property crisis.

The People’s Bank of China (PBOC) cut two key interest rates as it stepped up efforts to boost the economy. The central bank cut the five-year loan prime rate (LPR), a reference for mortgages, by 15 basis points to 4.30% and trimmed the one-year LPR by a smaller-than-expected five basis points to 3.65%. The PBOC also lowered its seven-day reverse repo rate, an interbank borrowing cost. 

The State Council, China’s cabinet, outlined a 19-point policy package adding CNY 300 billion to state policy banks’ investment in infrastructure projects, on top of CNY 300 billion announced in June. The cabinet also allocated CNY 500 billion of special bonds from previously unused quotas to local governments. Despite these supportive measures, T. Rowe Price analysts believe that China’s policymakers have made clear that they wouldn’t flood the economy with excessive stimulus.  

Economic data released in August continued to reflect a slowing economy. Retail sales in July rose 2.7% year on year while industrial output advanced 3.8%, both below expectations. Home prices fell for the 11th straight month in July.

China and the U.S. Reach Audit Deal

On the geopolitical front, China and the U.S. struck a landmark agreement over the auditing of U.S.-listed Chinese companies. Under a preliminary deal announced on August 26, U.S. accounting officials will be allowed to review the audit papers of U.S.-listed Chinese companies. The agreement resolved a yearslong dispute that had threatened to kick off about 200 Chinese companies from U.S. exchanges. It was seen as a rare concession from Beijing, which had refused to give U.S. regulators access to the audit papers of Chinese companies on national security grounds. 

Tensions over Taiwan curbed investors’ risk appetite. Following U.S. House of Representatives Speaker Nancy Pelosi’s early August trip to Taiwan, Beijing said that it “will not renounce the use of force” to achieve unification with the self-ruled island after China conducted large-scale military drills to protest her visit.

Other Key Markets

Colombia

Stocks in Colombia, as measured by MSCI, returned -6.45% in August versus 0.45% for the MSCI Emerging Markets Index.

On Sunday, August 7, Gustavo Petro was sworn into office as the country’s first leftist president. In his inaugural speech, he focused on themes such as social equality, inclusion, and the environment. He highlighted several parts of the economy and society in which he intends to pursue reforms, including taxes, pensions, labor, and education. However, he did acknowledge that the changes would be fair and not confiscatory. He also said he would comply with and enforce the constitution. 

The new Petro administration wasted no time in unveiling its tax reform proposal. According to T. Rowe Price emerging markets sovereign analyst Aaron Gifford, the proposal aims to raise 1.7% of GDP in 2023 and 1.4% over the medium term through a higher tax burden on higher-net-worth individuals (e.g., more progressive tax rates), a reduction of corporate exemptions, and new taxes on hydrocarbons and mining exports above certain commodity price thresholds.

While the proposal, if implemented, would increase government revenues, Gifford notes that this is much less than the 4% of GDP that Petro had previously talked about. Although President Petro has working majorities in both houses of Congress—which increases the likelihood of tax reform becoming law—Gifford would not be surprised to see some watering down of the reform proposal before passage.

Turkey

Turkish stocks, as measured by MSCI, returned 22.70%. On Thursday, August 18, Turkey’s central bank unexpectedly reduced its key interest rate, the one-week repo auction rate, from 14.0% to 13.0%. According to the post-meeting statement, policymakers justified the rate cut by indicating that they expect the “disinflation process to start on the back of measures taken and decisively implemented for strengthening sustainable price and financial stability.” Policymakers also claimed that “leading indicators for the third quarter point to some loss of momentum in economic activity” and that it is “important that financial conditions remain supportive to preserve the growth momentum in industrial production and the positive trend in employment.”

With headline consumer price index inflation in July at a year-over-year rate of nearly 80%, and with corporations lobbying for the ability to adjust or revise their financial statements to reflect the elevated inflation environment, T. Rowe Price sovereign analyst Peter Botoucharov notes that the rate cut confirms the central bank’s support for President Recep Tayyip Erdogan’s “New Economic Program”—at least until the June 2023 presidential and legislative elections. The goals of the program, which is based on a highly stimulative monetary policy and an exchange rate that increases the competitiveness of Turkish exporters in world markets, are stronger economic growth and job creation. The downside of these policies, however, is higher inflation and a weaker lira.