Financial update from Brewin Dolphin - 26 August 2022

August 2022

The Weekly Round-up

Friday 26 August 2022

In this week’s round-up, Janet Mui, our Head of Market Analysis, discusses what’s next for US interest rates, UK energy prices, and infrastructure stimulus in China.

Jackson Hole

Jay Powell’s, chair of the US central bank, highly anticipated Jackson Hole symposium speech arrived today. Powell’s speech was actually in line with market expectations but, overall, was on the more hawkish side. He clarified that the July softer inflation print falls far short of what is seen as sufficient and the Fed is very cautious not to pause prematurely. The Fed will need to keep monetary policy sufficiently restrictive as inflation is far above target and that the labour market is still very tight. He acknowledged that there will be more pain to the economy, but again mentioned that at some point, depending on data, that rate increases could slow.

The immediate market reaction was a rise in US treasury yields and a sell-off in stocks. 2-year treasury yields are currently testing a new cycle high. Even with this hawkish speech, financial markets are still thinking that the Fed will eventually pause at 3.8% by mid-2023 (about where the Fed’s projections were in June 2022).

The implication for the equity market is that previous expectations of a Fed pivot seem premature and hence the short-term direction could be a reversal of the summer rally. Ultimately, these higher interest rates and a further economic slowdown will weigh on corporate profits later this year.

UK energy price cap lift

The eye-watering energy price cap lift adds another layer of financial worries for households, at a time when mortgage bills and grocery baskets are eating up an increasing share of people’s disposable income.

But the worst may yet be to come. The energy price cap could potentially hit over £5,000 in January and over £6,000 in April 2023, which will likely leave households with energy costs four times higher than last year.

What’s in store for 2023? What we know so far is that the benchmark European natural gas prices have surged to a new record high this week as Russia further limited its gas supply via its key pipeline. Shipments from the US and Norway have reduced in the recent week and there is stiff competition from Asian buyers. The picture could deteriorate further this winter, as the UK lacks gas storage capacity leaving it increasingly vulnerable to supply disruptions.

In short, wholesale energy prices are likely to soar further in 2023, which are sure to be reflected in each quarterly increase in the retail energy price cap. The UK is heavily reliant on gas as a source for electricity generation, and gas heats almost 80% of homes. It really looks like it will become a matter of choosing between heating and eating.

Higher gas prices also have a serious secondary impact on industries, food supply, and input costs to businesses, which are not protected by any price caps. Businesses soon to renew their energy contracts will be in for a shock. Some businesses may even find the costs unviable, at a point when households are tightening their belts.

With inflation expected to rise further, the Bank of England is now widely expected to increase interest rates from the current 1.75% to as high as 4% in 2023. That will cause further rises in mortgage rates, which have already doubled since the end of last year.

Financing costs will be higher and commercial banks may be more reluctant to lend as the UK is predicted to head into a recession.

The relatively positive thing, however, is that the UK labour market is holding up well with job openings remaining plentiful. Although households are seeing their wages lag price rises, the country is not in a situation where the economy struggles with high and widespread unemployment. Labour shortages are also forcing employers to provide cost of living support or bump up wages for their staff.

UK inflation outlook

Citi’s jaw-dropping forecast of 18% UK CPI by early 2023 is headline news. But how valid is this mind-blowing prediction? Well, putting a numerical forecast on inflation has always been difficult in normal times, but the uncertainty and volatility of European gas prices makes the task even tougher.

The Bank of England has consistently underestimated inflation for the past year and July’s inflation already reached 10.1% vs 9.9% forecasted at its August report. Given another double-digit surge in European benchmark gas prices this week (Russia will shut its Nord Stream pipeline for three days of maintenance work from 31 August), more price pressures are building in the quarters ahead.

As private sector economists can revise their inflation forecasts much quicker in reaction to market movements, we will sure see more financial institutions making these bold inflation statements. This is likely to further hit the public mood and risk putting consumers and companies off spending.

The latest UK industry surveys showed a significant weakening in manufacturing activity due to the high cost of doing business and weak demand. While the services sector is still holding up, households’ finances are set to be tested and stretched to an extent not seen in many years.

Sterling outlook

Given the grim UK inflation forecasts and the weaker growth outlook, sterling has taken a tumble vs the US dollar. Despite the backdrop of the UK 10-year gilt yield hitting a new cycle high of 2.69% this week and narrowing the interest rate differential between UK vs US sovereign yields. The change in relative interest rate differentials is something that impacts the value of a currency. But the movement in rate spreads has done nothing to stem the sharp decline in the pound.

Nominal rate spreads typically work well as a driver for currencies, but real rates spreads in theory are more important - they become particularly useful in practice when inflation differentials between countries start to deviate a lot. On that front, the real 2-year bond yield spread has moved against the UK. With some forecasters suggesting UK inflation will hit 18% next year, at a time when US inflation is expected to decelerate, this real rate differential should continue to move against the UK over the medium term.

A big part of what is driving up inflation in the UK relative to the US is natural gas. Prices have gone up in the US, but not nearly as much as they have in the UK, where they have hit new highs. Not only does this make for higher inflation in the UK, but it will also result in weaker growth. After paying for energy, consumers and businesses will have less income left over to spend on other goods and services. And companies will continue to resist raising wages at the pace of headline inflation. This makes it likely that industrial action will get worse, which will further weigh on growth. More frequent strikes also hold back the supply side of the economy, which also has inflationary consequences. Relatively high inflation and relatively weak growth is a poor backdrop for a currency.

As the government is likely to pledge more support to households on energy bills, and given Truss’s planned tax cuts, we’re likely to see UK government debt dynamics deteriorate relative to the US. And we’re also likely to see the UK run a massive current account deficit this year and next, exceeding the record low the International Monetary Fund forecast just a few months ago. Neither of these two developments are welcomed by currency investors. There is a risk of future events that will keep the pound cheap. One is the risk of a renewed flare up in tensions with the EU over Northern Ireland. Another is the uncertainty around a potential Scottish referendum. The bottom line is that even though nominal interest rate spreads are now moving in a pound friendly direction, like the euro, it’s still probably too early to believe the pound has hit bottom vs the dollar.

The golden dragons rallied

Despite plenty of bad news coming from China including a slowing economy and real estate crisis, good news in relation to supporting the economy and tackling the problems is also in abundance.

Following the surprise cut in the key policy rate last week, Chinese banks have lowered their 1-year and 5-year loan prime rate, with the latter being a reference rates for mortgages. With regards to mortgage boycotts, the authorities have announced that special loans will be offered to Chinese property developers to ensure uncompleted project will be tackled and delivered to home buyers. Furthermore, the State Council outlined a 19-point policy package including a further 1 trillion yuan of stimulus mid-week, largely focused on infrastructure spending. The policy package will include support to businesses, energy supply, agriculture funding, but most of it will be via infrastructure.

The focus on infrastructure highlights that it is difficult to go beyond the traditional way of stimulating the economy via infrastructure. As long as a stringent covid policy is in place and confidence on the real estate sector remains poor, these policy interventions may not be enough to defend the growth target of 5.5% this year. Nevertheless, these are clear signs that China is stepping up to address the current real estate crisis.

During the week, Chinese tech giants got a boost from reports that there is progress on talks between the US and China to avert the delisting of Chinese companies listed on New York Stock Exchange. China regulators have instructed major accounting firms to prepare to bring audit work papers of US-listed Chinese companies to Hong Kong, where they can be reviewed by US officials. The Nasdaq China Golden Dragon Index surged +6.3% on Thursday on the news. The development is in line with our view that the regulatory crackdown in China has reached its peak.