Financial update from Brewin Dolphin - 16 September 2022

September 2022

The Weekly Round-up

Friday 16 September 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses recent events in the Russia-Ukraine war, as well as US and UK inflation figures.

Ukraine fights on

One of the most significant bits of news this week was the successful counter-offensive gains made by Ukrainian forces. During five days of fighting, Ukrainian forces reclaimed territory equivalent to all of the gains Russia had made in the prior five months. The reclaimed territory exposed Russian positions, causing some hasty retreats and the abandonment of a lot of military hardware.

The loss has been severe, both strategically and psychologically. Whether that is the reason for the change in tone from Russia’s propaganda machine or not we can’t tell, but it is notable that Russian media are reporting on Russian losses for the first time. Previously, setbacks had been denied, ignored or even described as goodwill “giveaways” towards the Ukrainians.

The territorial gains coincided with better stock market performance at the beginning of the week. It is, of course, imperative that President Vladimir Putin’s aggression is shown to fail, if only to check any further ambitions he or his advisers may have. However, that seems too abstract to be reflected in the prices of ever-pragmatic financial markets.

Now, attention turns to the various unattractive options available to this self-styled strongman who has suffered a humiliating setback.

Putin’s options

The chances of Putin accepting defeat seem vanishingly small, suggesting an unholy trinity of responses for a chastened former superpower. The most likely option seems to be that Russia will target civilian infrastructure and submit Ukrainians to a harsh winter without basic utilities. A further option would be to double down by upgrading the special military operation to war, which would then open the possibility of conscription. The most chilling possibility would be that having been shamed in conventional combat, Russia resorts to its unconventional arsenal.

So while Russia’s humiliation might be considered necessary or just, it does not mark significant progress on the route back to a pre-invasion status quo. Whatever happens now, Russia seems destined to near-complete isolation for as long as can possibly be foreseen. The distant possibility of a change in Russian leadership, and the even more distant possibility of a new leader taking a more globalist approach, would surely not tempt Europe to be as reliant on one state for energy supplies as it once was.

US consumers digest higher prices

The US economy still seems strong. As far as we can tell, consumers have very robust household balance sheets and, for the fifth straight week, initial jobless claims have declined. They are now at their lowest level since May, and throughout that period they have been consistently undershooting expectations. This suggests the US labour market could be even tighter than originally expected, and perhaps explains why the US consumer price report was a bit of a shock to the markets.

The headline consumer price index (CPI) rose by 0.1% in August from the previous month, whereas it had been expected to decline. The surprise increase and the monthly rate were not particularly shocking overall, except for the fact they were both depressed by gasoline prices.

The real concern came from core CPI, which excludes volatile items such as oil and food. Here, prices rose by 0.6% in August alone, which was double what had been expected. When looking through the detail of the report, it lacked the distortions of airline fares or used cars that had contributed to some of the really high inflation rates in previous months. Instead, this was more evidence of a general trend of price increases, with companies seeking to protect margins and consumers seemingly willing to pay these higher prices.

The report will raise concerns about a wage-price spiral once more and seals the deal on a 0.75 percentage point interest rate increase next Wednesday. A larger increase is a possibility, but I suspect the Federal Reserve would have wanted to hint more explicitly that this was possible.

By way of mitigating evidence, a survey from the National Federation of Independent Business suggests some reduction in demand for labour and less willingness to raise prices than in previous months – but reduced willingness does not mean unwillingness. Generally, surveys of consumers and businesses suggest that people are worried about the future but are living in the present where the hard data continue to show pretty robust economic demand and tight labour and product markets.

Fed marches on

This raises a question about how high US interest rates could go. The concern on this front is that monetary policy operates with long and variable lags. The first increases in bond yields immediately closed off the ability of US consumers to use their houses as an ATM and borrow against them to fund consumer spending. Thereafter, as yields continued to rise, higher mortgage rates made house purchases less affordable, which in turn has seen a reduction in house building activity. This week saw the 30-year fixed-rate mortgage rate exceed 6% for the first time since 2008.

This leaves further scope for the housing sector to slow activity. What we have yet to see is outright house price declines, which eventually feed through into lower shelter CPI. Assuming prices do eventually fall, there is a long lag before they start reducing CPI.

Other parts of the economy are less sensitive to interest rates, but small business capital investment intentions do seem to be falling which, logically, would follow from an increase in borrowing costs. For larger companies globally, bond issuance has declined as rates have become punitive.

UK showing signs of fatigue

The equivalent data from the UK is a little more circumspect. UK inflation is higher than US inflation, largely because of energy price increases. Like the US, headline inflation eased due to lower petrol prices, but the effect is much more subtle, diluted as it is by the high levels of fuel duty imposed in the UK. Core inflation rose by 0.8% month-on-month which, again, seems worse than the US, but the UK number is not seasonally adjusted and tends to jump during August. Taking that into account, this is the lowest amount by which CPI has exceeded its average since last October. Inflation will rise this October despite the increase being pared back by the government’s energy bill price cap. Thereafter, it seems likely that the rate of inflation will start to decline.

UK retail sales fell in August by more than had been expected. The added price pressure over the coming winter seems likely to diminish sales further. Even if the rate of inflation starts to decline from that point onward, the higher cost and greater seasonal use of gas and electricity will take their toll on consumers.

Next week, the Bank of England holds the monetary policy meeting that was delayed due to the national week of mourning for Her Majesty Queen Elizabeth II. Expectations are for a half percentage point increase. Beyond this, there is some speculation that the Bank of England may have to accelerate its pace of rate increases. This seems a little anomalous in the face of a weakening consumer and potentially easing inflation but, as we discussed last week, it is a more logical rection to the enormous fiscal injection which will bring about that flatter inflationary trajectory.

The pound slides again

The market still considers there to be more upside in UK interest rates than US rates, although that spread has narrowed a little since the US CPI report. In that context, why has the pound been so weak? Surely it should be supported by that more aggressive rate trajectory?

The problem is that the UK and Europe are suffering from a loss of competitiveness due to higher energy prices. For businesses to remain competitive, they need their labour to be more competitive on a global scale, and that is achieved through falls in the pound and euro. The best hope for a recovery in these currencies lies in relative falls in the marginal cost of energy (gas in Europe, oil in the US). We had been seeing that over the last fortnight, which probably explains why we started to see the dollar reverse some of its gains.

Such a weak pound prompts reminiscences of Black Wednesday and questions about whether it could be repeated. But the circumstances are very different. Black Wednesday occurred when the Bank of England was trying to peg the pound within the European Exchange Rate Mechanism, whereas now the currency is free floating. Others question whether the pound is akin to an emerging market currency. That seems unlikely, but there is an astronomical amount of bond issuance to be digested over the coming 12 months and little indication that there will be much fund raising or expenditure cuts at next week’s fiscal-event-akin-to-a-budget, which I really hope people will start referring to as the FEATAB.