Financial Update from Brewin Dolphin - 23 December 2022

December 2022

The Weekly Round-up

Friday 23 December 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses changes to the Bank of Japan’s yield policy and the outlook for US economic growth.

‘Twas the week before Christmas and, all around the world, markets barely stirred. However, in the world of finance we know that something will always break the calm; this week, it was the Bank of Japan’s monetary policy announcement.

A shock from the BoJ…

Very little was expected from the Bank of Japan (BoJ). The bank’s official line remains that current above-target inflation will moderate during 2023 and, therefore, an accommodative monetary policy remains appropriate. Sure enough, there was no change to the modestly negative policy interest rate or the target rate of 0% for ten-year government bond yields. However, the BoJ did widen the range that yields are allowed to trade either side of the target from plus or minus 0.25% to plus or minus 0.5%. Yield curve control was instigated in 2016 when quantitative easing was failing to deliver inflation, yields were falling deeper into negative territory, and the central bank was in danger of undermining bond market liquidity due to the share of the market which it was amassing.

One of the most controversial features of yield curve control was how it would ever be relaxed. Unlike interest rates and asset purchases, where central banks can offer forward guidance, with a yield target any expected change would see speculators shorting bonds which the central bank would feel compelled to buy in order to maintain the target. This could have the perverse reaction of causing asset purchases to rise at a time when policy is being prepared to be tightened, as well as providing easy profits for speculators that are funded by the central bank.

Yields back on the rise…

With yields bumping along the upper threshold of the permitted range, the general consensus was that a new central bank governor taking over from April would likely seek to relax yield curve control. But with surprise being such an important element of a successful withdrawal, the announcement is understandable without having been expected. The coming weeks will reveal how successful the strategy has been, particularly once the Bank of Japan ends the additional unscheduled bond purchases currently taking place to ease the transition.

Naturally, the market reacted by selling bonds such that their yield moved up towards the new upper threshold. Higher yields were sufficient to entice more investors to own the yen, which rallied having previously been the weakest major currency this year as Japan bucked the trend of rising rates in other markets. Stocks sold off, reflecting tighter financial conditions and the reduced value of overseas earnings expressed in the new stronger yen. Banks and insurance companies were the exception because they benefit from higher interest income.

Energy

Energy prices diverged this week with the oil price strengthening while gas drifted lower. Despite the cold snap in the UK last week, the winter continues to be a relatively mild one so far. Europe is drawing down gas from its storage facilities, but these remain above their average levels for the time of year. Supplies of liquified natural gas (LNG) coming into Europe meanwhile are at an all-time high, and will be aided by the opening of one of Germany’s new LNG terminals at Willhelmshaven in the new year.

China

China’s demand for energy has been depressed during 2022 due to Covid suppression measures, but with the economy reopening it is expected to recover…eventually. For the time being, though, the spread of infections and nervousness about catching Covid have depressed activity – in some cases even more than lockdowns.

Offsetting the weak demand for oil from China, US crude oil inventories have been drawn down to their lowest since 2014 (adjusted for the time of year). The weak dollar also supports dollar-priced commodity prices like oil.

Last week’s Central Economic Work Conference made clear that economic growth is now a priority for the Chinese Communist Party. However, in contrast with previous Chinese stimulus efforts, the party wants growth to be driven through consumption rather than infrastructure and housing investment. To this end, it seems likely that the focus of stimulus efforts will be monetary policy with fiscal discipline employed to tame China’s expanding elevated debt. The private sector may also benefit from an easier regulatory environment, with the internet platform companies that had been criticised for their wild growth a year ago being identified as playing a leading role in economic development.

Housing

The housing market in the US has been weak, reflecting the sharp increase in interest rates and high construction costs. A slew of housing market data reinforced the point this week, with new building permits falling to their lowest since the initial Covid lockdown. The NAHB housing market index, which measures sentiment among builders, fell to a new low for the year although the drop was the smallest this year, suggesting that a bottom is in sight. House building has been a drag on GDP but has been offset by reasonably strong business investment. Current levels of housing market activity are consistent with the previous instances of recession. Often, housing leads the economy because it is a very labour intensive and triggers a lot of clustered economic activity (building, selling, financing, moving and furnishing). Although mortgage rates have fallen recently, from 7% to 6.3%, housing is expected to remain a drag on growth throughout 2023.

Consumption

The real determinant of whether we experience a recession during 2023 comes down to the outlook for personal spending, as this is the largest and strongest category of GDP. This year has seen Americans spend an unusually high share of their income as costs have risen. For many, their ability to do so has been facilitated by dipping into their savings, which were inflated during the pandemic. For the lowest income cohorts, those savings will deplete during the first half of 2023; however, lower inflation and stronger wage growth over the last quarter reduce the pressure. The labour market remains tight, with a further decline in initial jobless claims this week, and the workforce has been depleted by early retirements since Covid. Wage growth should therefore remain strong and the biggest factor determining how healthy consumers remain will be inflation.

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