Financial Update from Brewin Dolphin - 15 July 2022

July 2022

The Weekly Round-up

Friday 15 July 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist explains that everything about markets at the moment is laced with nuance.

The main fear at the start of the year was inflation. Inflation is typically most heavily influenced by energy prices. Energy prices recently have been going down, which should alleviate that fear but the falling oil price itself is largely a function of increasing concern over recession risk. What did we learn his week? Inflation is still too high and recession risk is probably still tomorrow’s problem.

Inflation is Too High

A fake CPI report showing double-digit US inflation circulated on Twitter on Tuesday and sparked much anxiety until it was discredited. However, when the actual report was released it was not much better. Inflation hit 9.1% in the year to end to June after rising a surprisingly strong 1.3% during the month. That was significantly worse than Wall Street had been expecting. Of more importance than headline inflation is core inflation, because we knew that gas prices had been inflating the headline measure during the survey period in June. Core CPI did offer a silver lining in that the annual rate of CPI excluding volatile food and energy prices did slow but that reflected base effects rather than any let up in the rate of inflation as the monthly print was the strongest in a year.

Looking at the breakdown there have been some key categories that have driven inflation over the last few months.

Higher interest rates, causing higher inflation, have put a hold on new home sales. Unless bond yields retreat, home prices will have to fall, or at least stop rising, until affordability improves. Eventually, this will be reflected in lower shelter inflation, but that is likely to take several months.

With a half a month to go, it looks like energy inflation ought to be a disinflationary factor during July’s CPI report. Similarly, food prices should also come down with agricultural commodities in widespread retreat. These again tend to hit CPI with a lag and so should provide some scope for price falls in future months.

So Have We Seen the Top?

So the question is, have we seen the top in inflation? The answer is probably, but it has seemed like the top for the last few months. There are several material unknowns driving these major commodity prices – such as the war in Ukraine. And the real challenge in these numbers is not so much the big categories like oil and rent, or the outliers like car prices and airline fares. It’s the smaller, broader sources of inflation and their persistence. Various alternate measures of CPI strip out the more volatile prices, but which ever you use they are all still signalling accelerating inflation.

That means the market expects the Federal Reserve to act and is beginning to ponder the possibility of a 100 basis point rate increase at the end of this month, as they recognise the need to get out in front of this inflation train. Fed speakers, even the most hawkish ones, seemed to downplay that possibility.

Is the US in Recession?

The CPI report caused interest rate expectations to pick up again, but the market discounted increased recessionary risks with lower longer-term yields.

The market expects rates to start being cut early in 2023, prompting a lot of discussion about the risk of stop-start policy as was experienced in the 1970s, when policy was loosened too early in response to a weaker economy. It will be a really difficult balance to strike and will depend, in part, on how inflation and wage expectations evolve. For the moment, though, even with the first indications that real growth could stay negative due to inflation, consumers are dipping into capacious savings rather than meaningfully scaling back their purchases.

Investors and consumers are all suffering from a chronophobia, or fear of the future. JPMorgan Chase CEO Jamie Dimon has been bracing the bank against the onset of what he calls an economic hurricane but, for now, he poured cold water on current recession fears, saying that the consumer is in great shape and, with their access to bank account data, the big banks are worth listening to on this subject. Sure enough, this afternoon’s retail sales numbers were better than expected. Even after adjusting for inflation, retail sales excluding car sales were probably just positive.

Finally, the University of Michigan Consumer sentiment index was being scrutinised for signs that inflation expectations might be accelerating. As it was, they receded to their lowest in a year. Still too high but likely to give the Federal Reserve considerable comfort. Consumer sentiment improved too, Americans love cheap gasoline!

Political Crisis in Italy

Italy is at the heart of challenges faced by the eurozone and, recently, the decline in the euro has been reflected in the stretching of yield spreads between Italian and German bonds. Italy has the second highest debt to GDP ratio in the eurozone (after Greece) and suffers from a growth headwind largely due to the declining population.

Italy has courted political instability on many occasions. It has many political parties, representing a wide spectrum of views. The largest of them currently barely poll above 20% of the vote, meaning that coalitions are inevitable (and fragile).

In January last year Mario Draghi, former president of the European Central Bank, formed a government, which was supported by most Italian parties, including the League, Five Star, PD and Brother of Italy.

Italy is one of the most reliant countries on Russian gas. The Draghi government proposed a 25% windfall tax on the energy companies’ excess profits to generate funds to cushion millions of financially vulnerable families, including pensioners, with energy subsidies and a one-time €200 cash payment.

However, the Five Star party did not feel the package gives enough support to families facing higher food and energy bills and so has withdrawn support for Draghi’s government. Despite that withdrawal, the package was approved in the Italian Senate quite comfortably.

What Next?

This is because Draghi’s coalition is so broad that it actually can govern without the support of Five Star. However, he always made that breadth of support a condition of his tenure and hence the need to offer his resignation. That resignation was rejected (for now).

If Draghi were to have a resignation accepted, then it would take weeks to hold an election. Right now, it would be mid-September at the earliest due to a constitutional restriction on when the budget needs to be prepared by.

There’s scope for a calmer assessment of the situation after this latest event, albeit spreads have been wider earlier this year anyway. However, a forthcoming test will be the ECB announcing its antifragmentation tools, which we can only imagine will reflect some form of conditional bond buying programme – economic reforms for collective underwriting of debt.

Challenges Remain

That will be a difficult sell to countries like Italy, who need to accept the reforms, and countries like the Northern European states, who will feel they are on the hook for the underwriting. Furthermore, energy prices remain the biggest headwind for Europe already, and outright supply shortages could become devastating – all of which will be particularly divisive and challenging for Italy.

Europe is therefore our most significant underweight.