Financial Update from Brewin Dolphin - 13 October 2023

October 2023

The Weekly Round-up

Friday 13 October 2023.

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the impact of oil price volatility on inflationary pressures, as well as the potential for further Federal Reserve rate hikes.

One of the drivers of markets during the second half of the year has been the volatility in the oil price. It rose sharply but was in the process of sliding back even more sharply when last weekend’s horrific attacks on Israel took place. So, at the start of this week, there was an oil price spike reflecting the possible risk to oil supply that geopolitical tensions in the Middle East can prompt.

Israel has been taking retaliatory measures and is expected to mount a ground invasion that seems likely to result in significant casualties. The conflict has broadened as Hezbollah has said it is ‘prepared’ to step up activity on the Lebanese border, and there is a risk that it could eventually also encompass Iran. If so, this could disrupt oil production but would certainly make it harder for a deal to be reached that might see Iranian oil return to the global market (although the chances of a deal had seemed fairly remote anyway).

Oil has been volatile this week in response, but broadly edged a little higher as the days passed.

High oil prices spark inflation fears

Oil price shocks are considered to have been a significant cause of recessions in the 1970s and 1990s, but have also been a lesser factor in several other recessions. Rising prices cause consumers to cut back on discretionary spending and can exacerbate inflationary pressures. That would be a particular concern today when many economies have limited spare capacity, and when, until recently, employees have found it relatively easy to argue for higher wages.

Early in the week, US Federal Reserve board member Michelle Bowman warned that elevated energy prices would hinder the return of inflation to its target rate and emphasised that a further rate increase would likely be necessary. This was in keeping with minutes this week that revealed that a majority of Federal Open Market Committee (FOMC) members felt that one more rate increase would be appropriate. Since then, a few things have changed; the oil price rise reversed, for a while at least, and Treasury yields have surged.

Bowman has been one of the most hawkish members lately, so it was no surprise to hear her holding the line on the need for further tightening, but other members were more openminded. Vice chairman Philip Jefferson and San Francisco Fed chair Mary Daly (who will be a voting member next year) both highlighted rising yields as a form of tightening policy that will reduce the need for further tightening of short-term interest rates. The rise in yields has taken place since the last FOMC meeting was held, so it is likely that some members feel a little less hawkish now than they did then.

House speaker chaos continues

From a policymaker’s perspective, appointing a new speaker was on the to-do list this week, and the ignition of an international crisis makes that of paramount importance.

US house Republicans began the week expressing optimism that they would have a new speaker of the House of Representatives in place by mid-week. Sometimes, politicians manage to find a path through what seems like an unnavigable sea of conflicting interests. This was not one of those times. So far, the process has presented a series of candidates around whom the Republicans cannot coalesce.

At the time of writing, the US lower House remains rudderless, leaving the status of additional funding for Ukraine unresolved and a limited budget available for responding to the Israel-Hamas conflict. So, how will this get resolved? It seems quite possible that Republicans will not find a mutually supported candidate (they can afford just four dissenters amongst their members) and will need Democrats to support a more moderate candidate.

Against this backdrop of dysfunction and crisis, data was broadly supportive of the US economy drifting towards a soft landing, with interest rates reaching a peak that curtails inflation without breaking the economy. At the margin, it would have been encouraging to see inflation slow, but in the context of September’s energy price increases, it was not surprising to see a modest pickup. There will be some anxiety over the pace of core inflation measures, but it would probably require some more persistence for these to start affecting investors’ expectations. For now, the market remains expectant that interest rates have reached their peak. At the same time, data from the National Federation of Independent Business’ survey of small businesses saw implied increases in the prices firms are charging and the difficulties of hiring, both of which would clash with the peak rates narrative if they became persistent.

UK economy remains sluggish

We also saw a lot of data released for the UK, which reinforced our view that the UK is economically weaker than the US and that UK bonds therefore ought to be discounting lower interest rates than their US counterparts. Companies have struggled to sell discretionary items during September. That doesn’t just relate to the weakness of demand, but also reflects the relatively warm weather allowing people to put off refreshing their winter wardrobe.

A survey on the labour market found evidence of demand dropping, with starting salaries rising at their slowest pace in two and a half years in September and overall demand for staff starting to decline.

UK GDP for the month of August grew marginally in line with expectations. It was held up by a modest increase in the large services sector, which offset declines in the manufacturing and construction sectors. Furthermore, the decline in the economy during July was revised from -0.5% to -0.6%, making it likely that the economy will have overall contracted during the third quarter. The question for the headline writers is whether the UK economy will also decline in the fourth quarter, marking a recession. It seems quite possible, but not that important, as growth is likely to be either modestly positive or modestly negative either way.

The end of this week saw the beginning of the third quarter earnings season, which will offer a huge amount of information to digest in terms of companies’ own experiences of demand and the commercial outlook.