Financial update from Brewin Dolphin 13 May 2022

May 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, explores the latest UK GDP figures, the escalating conflict in Ukraine and US inflation.

This week felt like a very difficult one for equities, although most of the challenges existed within the US market. Even with a stronger dollar providing a bit of relief, at the close of trading on Thursday US stocks were about 5% lower than at the beginning of the week. The week began with growth underperforming, but over the week we saw a subtle change permeating across asset classes. Whereas for most of 2022 stocks and bonds had been gaining or losing together, this week they seemed to resume their negative correlation. That could be a sign of growth worries beginning to trump inflation concerns. The same could be said for currency pairs where the US dollar resumed its outperformance of most other currencies, but on Thursday was left in the shade by a surge in the yen. Normally the yen would outperform when investors are worried about growth, but it’s been marked in its underperformance during 2022. The yen’s defensive properties are believed to stem from its current account surplus, but this shrinks when energy prices are rising because Japan is heavily reliant on imported energy.

UK GDP

The outlook for economic growth is quite mixed. UK estimated gross domestic product (GDP) in the first quarter was underwhelming and monthly data seemed to show stagnation in February and March. Since then, utilities bills and national insurance have risen, placing increased pressure on consumers. In March, consumer-facing services declined, suggesting that inflation may already be prompting some consumers to temper their non-essential spending. It seems quite possible that the UK could be close to meeting the technical definition of recession (two consecutive quarters of economic contraction) for the remainder of this year. That would leave it vulnerable to a more pronounced downturn were it to suffer any further shocks, the most obvious source of which would be Russia and its disastrous conflict in Ukraine.

Escalation in Ukraine

There was, therefore, plenty of focus on president Vladimir Putin and his speech at Russia’s Victory Day military parade. Speculation had been rife that he might use the opportunity to reclassify the special military operation as a war, which would be required if he wants to order conscription and escalate Russia’s commitment. Or maybe he would threaten the use of unconventional weapons? In a sign of Russia’s scaled back ambitions, the speech did not refer to broader Ukraine at all but instead focused on the narrower ambition of Donbas.

Geopolitical tensions may be escalated by Russia’s opponents as Finland and Sweden debate joining NATO – something which they had both historically considered would be an unnecessary provocation of Russia at a time when East and West seemed to be maintaining a stable balanced relationship. Putin’s invasion of Ukraine has prompted potential members to choose sides – another way in which it appears to be a severe strategic blunder. A further escalatory act came when Ukraine switched off gas transmission on the basis that it was no longer able to safely operate the transmission mechanism through regions that were controlled by Russian troops. Doing so starves Russia of cash and European countries such as Germany and Italy of gas, something they have only so far been able to threaten they will move away from over the long term. The Ukrainian grid also accused Russia of stealing gas from the pipelines. Ukraine said Russia would need to reroute the gas through a different pipeline. Russia’s next step, however, was to sanction a group of Western energy suppliers and consequently shut off gas to them via another pipeline, this time flowing through Poland. Gas prices rose from around €90 to €106 per megawatt hour in response to the tightening supply and indications that Russia is willing to use energy supply as a weapon.

Higher prices and potential outright shortages of gas are considered to be factors that would likely tip Europe into recession were it to be deprived of Russian gas. The threat feeds the narrative of shortages contributing to inflationary pressures that has been the defining feature of this year’s turbulence.

US inflation

The key piece of economic data this week was US consumer price inflation. Investors were hoping for confirmation that the annual rate of inflation had peaked in March. Inflation rates did in fact fall in April. However, these consumer price data were heavily nuanced. Despite the falling annual rate, an acceleration in the more influential monthly rate left investors downhearted. The data were skewed higher by some categories associated with the reopening of the economy, most notably air fares and hotel rooms that are unlikely to repeat at their extraordinary pace. But they also featured a heavy contribution from rent and owners’ equivalent rent (a category which equates to the monthly expense of owning a property). These seem destined to continue to climb over the coming months due to the increasing cost of properties.

An additional challenge has been Covid lockdowns in China. These have delayed deliveries and clogged up supply chains adding to inflationary pressures, but they have also resulted in reduced domestic demand in China. Furthermore, the general reopening has seen consumers switching from their elevated levels of goods demand to seek out more services, particularly travel. This was reflected in the sources of inflation from the US.

Interest rate trajectory

Despite the nuance, most would agree that this was not an inflation report that would help policymakers to sleep at night and many speculated that it would encourage them to think about escalating the pace of interest rate increases to an extraordinary pace of 0.75% per month. That currently seems unlikely. Inflation expectations seem restrained, making a wage price spiral less likely. That view seems to have been endorsed by policymakers since the report, with both Jay Powell and current arch hawk, James Bullard, stating clearly that a 0.75% hike is not in their current thinking. Fed speakers do seem to have coalesced around the idea of a further two 50-basis-point hikes though, which themselves represent an extraordinary pace of tightening, unprecedented alongside quantitative tightening.

Listening carefully to European Central Bank speakers, we also seemed to get some almost explicit guidance that interest rates in Europe will increase from July after asset purchases halt in June. The Bank of England has perhaps the most uncertain trajectory of rate increases with growth expected to remain subdued for the next two quarters. Currently a relatively slow pace of rate increases is forecast