Financial Update from Brewin Dolphin - 27 May 2022

May 2022

Friday 27 May 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the current health of the global economy and assesses the impact of the UK’s windfall tax.

Markets managed to make progress during the final full week of May despite plenty of continued anxiety over inflation, interest rates and growth.

This week gave us an opportunity to check in on the health of the global economy. There’s something quite surreal about the current environment, with widespread dissatisfaction despite generally low levels of unemployment around the world. It is truly remarkable the way in which inflation has leapfrogged unemployment. It is the critical issue of the day, although this shouldn’t be surprising given the negative impact it has on everyone from the wealthy to the less well off.

A health check on the global corporate sector

Purchasing managers’ indices (PMIs) are designed to gather an impression of how companies are performing across some generic categories. They are broken down into regions, and occasionally sectors, and currently reflect an environment in which growth remains firmly positive but is slowing.

That slowdown was generally a little more pronounced for the manufacturing sector, reflecting the shift in demand away from the goods that had sustained people during the pandemic and towards the experiences they have been missing out on, most notably holidays and eating out.

UK services slump

An exception to the greater resilience of services seems to be the UK. It is important to note that the UK services PMI remained above 50, implying the sector continues to expand, but it nevertheless slowed very significantly indeed during early May. It would be easy to dismiss the reading as an anomaly, but we knew to expect some impact this month as UK consumers were saddled with higher energy bills and higher national insurance deductions which hit home during April. May’s data gave the first impression of how significant that is. The question now is whether the easing of demand serves to reduce price pressures. The survey suggested companies are reportedly finding it harder to pass on cost increases to consumers.

Bills pain

With cruel timing, an Ofgem submission to Parliament’s Business, Energy & Strategy Committee revealed that its current estimate of the energy price cap increase in October would see it rise to around £2,800. This is by no means guaranteed but as a best current estimate it stands out as being well over double the level in October 2021 and would see energy costs demanding the highest share of consumer wallets on record (dating back to the 1950s).

Windfall tax

The government was moved to respond early to this threatened increase, announcing a tax on energy company profits. The tax had little impact on oil and gas stocks as it is applicable only on UK profits. These form a relatively small share of the profits from the largest UK-listed diversified oil and gas majors.

The greatest concern among critics of the move was that taxing the benefits of previous investments would diminish the incentive to make future investments. Energy policy is in an awkward place at the moment, with policymakers more aware than ever of the benefits that could come from being less reliant on fossil fuels, but also aware that, until alternatives are developed, fossil fuels are a necessary resource. Recent reductions in investment have been a contributing influence on the current high level of oil prices, along with more obvious factors like the war in Ukraine.

To attempt to address this, the government offered an 80% allowance for new investment in UK oil and gas assets. That seems likely to be enough to encourage BP and Shell to continue with the investment programmes they had previously committed to.

Implications for interest rates

Discouraging investment was the main criticism of the windfall tax. However, the tax is there to provide relief to families who are suffering from the sharp increase in the cost of living. Nobody would doubt the need for this, which will come in the form of deductions from energy bills for all and targeted payments for pensioners and the most vulnerable groups. This aid will reduce, but not fully negate, the impact of the October rise in fuel bills, but will form a meaningful injection of spending into the economy at a time when demand is already exceeding supply and causing uncomfortably high inflation. That complicates the hand of the Bank of England, which would like to raise rates more in order to face the new and existing inflationary threat. But the Bank will also be focussed on the weak signal from the service sector PMI which might tempt it to provide some relief. Absent any evidence of the employment demand weakening, it seems unlikely that the Bank of England can be too cautious about raising interest rates.

Populist measures

Outside of the UK, other governments are considering their own windfall taxes. Hungary, which remains a stumbling block in terms of building a consensus to frustrate Russia’s oil sales, announced multinational companies would be required to turn over most of what prime minister Viktor Orban described as their ‘extra profit’. This will be used to subsidise utility bills and pay for the cost of modernising the Hungarian armed forces.

In China, premier Li Keqiang convened an emergency meeting with thousands of attendees representing local governments, state-owned companies and financial firms. He called upon them to stabilise growth, describing the current level of activity as worse than in the immediate aftermath of Covid-19.

US housing

The US economy continues to be supported by strong demand but is showing some signs of weakness. Focus has been on the housing market which has lost momentum since bond yields and property prices have risen sharply. This undermines affordability and has seen a collapse in refinancing activity, a mechanism which allows low interest rates to drive lasting reductions in consumers’ mortgage payments, thereby enhancing consumer spending.

New mortgage transactions also seem set to reduce with pending home sales (sales which have been agreed but not closed) declining for six straight months. A second reading of first quarter US gross domestic product (GDP) revealed a revised-down figure for residential investment, again remaining just modestly positive. Residential investment is not a big category of GDP, but it does tend to be watched closely because it is quite labour intensive and drives a lot of subsequent economic activity (moving, furnishing etc) as well as ultimately aiding the supply side of the economy by supporting labour mobility.

Despite the gloom, markets actually performed pretty well this week. Much of the news was expected and after a few troubling weeks markets were already depressed. In times of weak market sentiment, that weakness provides subsequent support. As we approach the end of the quarter investors remain very cautiously positioned and markets should benefit from rebalancing flows from pension funds with very prescriptive strategic asset allocations.