Financial update from Brewin Dolphin - 10 June 2022

June 2022

The Weekly Round-up

Friday 10 June 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the latest US inflation figures and hawkish comments from the European Central Bank.

The main news for this week was released on Friday afternoon with the US consumer price index (CPI) coming in well ahead of expectations. Prices rose by 1% in May alone. Many of us had hoped to see the peak for inflation in April, but the volatility of food and energy prices means that headline inflation is almost impossible to accurately predict. And indeed, it was these categories that drove the biggest parts of May’s increases.

Excluding food and energy gives a clearer picture of the kind of inflation a central bank can hope to control and the picture here was less bad, but still not good. Prices rose by 0.6% in the month or accelerated to 6% on an annual basis. The contributors were similar to last month, with airfares making an outsized contribution. These are volatile components which should arguably be excluded from a core measure of inflation. In fact, some alternate measures seek to do just that – for example the Cleveland Fed’s trimmed mean CPI takes out the biggest positive and negative contributors to CPI. It fell to 5.5%, the lowest since August 2021. That’s much less scary than the headline rate. There’s no question that it’s still too high, but it is coming down. These trimmed mean measures do seem like a more appropriate gauge of the inflationary pressures in the economy.

The other thing evident from the data was the shifting balance between goods and services. Goods demand during lockdown compensated for services that could not be enjoyed. This month, TVs and computers were among the sectors seeing prices falling. Now services demand is enjoying a surge, but that will slow a little in the coming months as people sate their pent-up need to get out and about.

Real wages under pressure

The most fundamental underlying driver of inflation would be the shortage of labour, which has seen wages increasing but not as fast as prices. This has allayed fears of a wage-price spiral which reduces the scope for inflation to become self-feeding. However, with the labour market so tight, why aren’t workers demanding that their wages keep up with prices? Wages are renowned for being sticky – employers typically only review wages once per year, employees may not wish to sacrifice everything they like about their job just to seek a higher wage elsewhere, and they may not be experiencing inflation as high as the current headline rate. They also have large cash balances from pandemic-related savings which mean their bank balances are not noticeably dwindling towards the end of the month in the way they do when inflation is normally high.

For whatever reason the average consumer’s impression of inflation tends to be a bit sticky too. Today saw the release of the Bank of England’s survey of inflation attitudes. It revealed that on average consumers believe inflation is 6% whereas official statistics measure it at 9%. What is worrying though is that respondents to the University of Michigan’s survey of inflation expectations really pushed up their estimate of the expected long-term rate of inflation from 3% to 3.3%. That’s a level it last touched, only briefly, in 2008.

Inflation in the UK is the highest of the major markets at the moment and is just a little ahead of the US and the eurozone. So far, the European Central Bank (ECB) has been slow to get into inflation fighting mode but this week it really started to get to work.

The ECB prepares to act

The ECB announced it will end asset purchases at the beginning of July and raise interest rates later that month (they meet on 21 June). Although widely anticipated, the tone of the announcement was considered to be hawkish with expected interest rates over the next year rising. That saw the euro weaken though, and this is because the ECB is in an awkward position now. The single currency survived an existential crisis during 2011 and 2012 as investors began to discriminate between core and peripheral member states, based upon their perceived ability to service their debt. Ultimately a crisis was averted by the then-president of the ECB, Mario Draghi, who announced that the central bank would do whatever it takes to maintain the integrity of the currency union, before adding, with calculated bravado: “And believe me it will be enough.” He said this safe in the knowledge that a eurozone struggling from a crippling weakness in domestic demand could accept virtually unlimited monetary stimulus, which in turn could underwrite peripheral European bonds, without triggering inflation.

Ten years later his successor, Christine Lagarde, needs to make good on Draghi’s promise, but the circumstances are much less favourable now. Inflation is rising which makes the case for unlimited monetary easing much harder to make. Acknowledging this, Lagarde pointed out that the ECB had shown flexibility and innovation when dealing with fragmentation (a euphemism for eurozone break up) risks. What the ECB did wasto change the proportions of different countries’ government bonds that it invests in. Although new net purchases are ending in July, the ECB still reinvests the proceeds from maturing bonds which it can use to try and restrain rising yields on Italian debt, but its scope to do so is very much limited. There will need to be some more creative thinking to keep peripheral bonds from coming under sustained pressure.

European stocks had recovered the most from the immediate aftermath of the invasion of Ukraine, but we feel they are now our least favourite region.

By contrast, the story of recovery in Chinese equities continues to gain traction. CPI in China was a little below forecasts at just over 2%, while credit expanded and more stimulus is expected to boost the recovery from lockdowns that have been in place during the first half of 2022. Chinese authorities this week are understood to have concluded their investigation into the ride-hailing company Didi, while a host of new online games were also authorised, lifting the gloom on companies and sectors that had previously been considered to be at odds with the Communist Party’s common prosperity ethos.

So although the week ended on a sour note, there remain attractive opportunities to be found.