Financial update from Brewin Dolphin - 2 Sept 2022

September 2022

The Weekly Round-up

Friday 02 September 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, takes a look at the outlook for natural gas prices and what’s actually happening in the jobs market.

This week has been another difficult one for markets. Stocks and bonds have both fallen.

There are a few reasons for the declines in asset prices. Amongst them must be some nervous anticipation of this month’s doubling of the pace of quantitative tightening. From September onwards, the Federal Reserve will stop reinvesting the maturing proceeds for securities it currently holds, subject to a cap of $95bn per month. This should make yields a little higher, spreads a little wider and valuations a little lower.

Rates to head north

The more fundamental challenge for markets though is the trajectory and final resting place of interest rates. For much of the last decade markets have been comforted by the notion that the Federal Reserve will cut interest rates in response to a weakening of the economy. Lower rates justify higher valuations. So even though a weaker economy might be consistent with lower earnings, if the policy response increases valuations markets can seem to relish bad news more than good news. The flipside of this is that in an inflationary environment signs of a strong economy mean a rate increase is likely and could put pressure on valuations.

Jobs to eventually head south

Some of the bad news that has been reassuring for markets has been evidence that the labour market might be loosening, such as the rise in initial jobless claims between March and July. With economic activity slowing in response to the interest rate increases that have already taken place, it would be conceivable to start seeing unemployment start to rise, and that would be the best indication that the Federal Reserve could prepare to end its programme of interest rate increases (which would be good news).

The disappointment this week though, has been that some economic data has been a little too good. Initial jobless claims have stopped rising and have even fallen a bit over recent week. We have had a mixed picture from the purchasing managers’ indices. The most trusted of them, the Institute of Supply Management (ISM), surprisingly indicated that manufacturing orders had begun expanding again.

We believe that the Fed will want to be confident that inflation is coming down before it is prepared to stop hiking, and so could even be tempted to keep raising rates a little longer than it would do historically. Any signs that the economy is proving more resilient will harden its stance on inflation fighting.

Perhaps that’s why the good news seemed to go unacknowledged by the market.

Gas generally heading west

For example, the most crucial metric for many of us now is natural gas prices and their impact on heating and power bills. But natural gas prices fell by around 30% this week without triggering much optimism on European growth or inflation. The falls came despite the key event this week being a halt of flows through the Nord Stream 1 pipeline for three days to allow for maintenance. Every indication is that flows will resume on Saturday but, naturally, some observers fear that Russia may further curtail gas flows, already just 20% of their normal volume, as a new front in its proxy war with Europe.

In the meantime, the factors weighing on the natural gas price seem to be the relative success that Europe has had in filling its gas storage and the scope for this to allow the region to navigate the winter without forced rationing of gas (subject to Russian gas flows). Partly that success reflects lower gas consumption compared with similar periods in recent years. Demand may also be lower for the next few weeks because the European Centre for Medium-Range Weather Forecasts expects temperatures to be a little above average at the start of October.

This week has also seen the EU considering several ways it can reduce gas and electricity prices. European electricity prices are determined by the most expensive provider (gas providers now). This enables cheaper fuels (such as renewables) to earn higher profits, which should encourage more investment into clean energy. The price cap would work like a windfall tax on those higher profits. The proceeds of which could be used to generally lower bills.

Truss heading for Downing Street

How to help households with these extremely punitive gas and electricity bills will no doubt remain the key topic and controversy throughout the winter. Voting closes today for Conservative Party members electing the UK’s new prime minister. On Monday, we can be fairly confident that Liz Truss will be declared the winner. Sensing defeat, Rishi Sunak described his fears that overly loose fiscal policy could mean that the UK loses the confidence of the international investors who won large shares of UK sovereign debt.

The UK has, for many years suffered from ‘twin deficits’. The first deficit is one which the government runs by spending more than it earns each year, the second is a current account deficit which reflects, among other things, the fact that the UK buys more than it sells when trading internationally. These deficits result in UK sovereign debt being substantially owned by foreign investors and Mr Sunak believes that to retain those investors confidence is key.

Global investors heading for the exits?

It is striking to note that during the leadership contest credit default swaps on the UK have lurched higher, particularly relative to other large economies. However, in the overall scheme of things the move has been abrupt but small and the chances of the UK being unable to meet debt service payments are virtually nil – in extremis it could print the necessary pounds to make payments on its debt. However, therein lies the more likely prospect, that government bond yields could rise, to compensate investors for depreciation of the pound that would occur if the UK suffered too much inflation as a result of reckless fiscal spending or money printing.

It seems reasonable to observe that investors are worried about the future direction of UK economic policy. The pound was the worst performing major currency during August and gilts were the worst performing quality sovereign bonds, with the ten-year gilt seeing yields rise by a full percentage point. Rising yields do not immediately mean higher borrowing costs for governments but as the government issues new bonds, the costs of those new bonds will reflect the prevailing yield.

Neither candidate has given chapter and verse on how they would address the fuel crisis, and the eventual winner will have more resources to do so. It may be that with the premiership secured for one of them, the kind of economic choices that have to be made seem less palatable than those discussed on the hustings.

Americans head back in the jobs market

One final positive point upon which to end the week, and in keeping with the bad news is good news theme, was that the market rose on the news of a rise in unemployment. Now this could have been considered a good thing for just reducing the incentive for further rate hikes (as discussed earlier), but this was more unambiguously good news than that. The reason for the unemployment rate increasing was because of an increase in people looking for a job (rather than existing workers losing their jobs). This just marginally increases economic capacity and so slightly diminishes the need for more aggressive Fed action at the next meeting.