Financial update from Brewin Dolphin- 5 August 2022

August 2022

The Weekly Round-up

Friday 05 August 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the latest UK interest rate hike and political tensions between China and the US.

A pretty reasonable week for markets saw modest gains across most regions. The weekend headlines, though, will no doubt focus on the doom and gloom coming from the Bank of England (BoE).

The MPC takes a hike

The Monetary Policy Committee (MPC) raised interest rates by 50 basis points (bps), which would imply it feels quite confident about the country’s economic prospects. This, however, is not the case. The BoE now expects the consumer prices index (CPI) to rise to around 10% in July and stay at this level for three months. It then expects inflation to jump to 13% in October when Ofgem’s price cap goes up by an estimated 75% (from £2,000 to £3,500 per year). As a reminder, the price cap was “only” lifted by 40% in April, so the one in October will have a significantly bigger impact. The rise in April was at a time when people were about to use their heating less too. The opposite will be true in October.

The pressure from commodity prices has previously been something that BoE governor Andrew Bailey felt was beyond the scope of the MPC to influence, therefore justifying a slightly more dovish stance. However, the Bank does acknowledge that the tight labour market is putting upward pressure on inflation. Almost all BoE agents report recruitment conditions as being either “quite” or “very” tight. The Bank is looking to slow demand to the extent that it creates some slack in the labour market and reduces wage-driven inflation. The main question is whether the BoE will hike by 25 bps or another 50 bps in September.

The UK takes a job

The UK Report on Jobs released this morning showed a further sharp increase in demand for staff, albeit the rate of vacancy growth slowed for the third month in a row. Companies are short staffed but are beginning to feel more worried about the future. They are right to feel so, according to the Bank. The BoE’s growth projections are much more pessimistic than other central banks. The Bank sees gross domestic product (GDP) contracting from the fourth quarterof this year, with the downturn lasting all the way through 2023, resulting in a peak to trough decline in GDP of -2.1%. For reference, if it works out this way, this would amount to a decline roughly on par with the UK recession in the early 1990s. Looking further out on the Bank’s forecast horizon, it sees the unemployment rate rising to 6.3% in 2025, well up from the current 3.7% rate.

The Bank takes a guess

There are a host of factors driving the pessimism on growth. One of them is the Bank’s own rate increases. Rightmoveestimates that the cost of a monthly payment on a mortgage taken out now will be 27% higher than was the case in January. But high natural gas prices are an even bigger headwind. On this front, the BoE itself acknowledges these are highly uncertain. According to the Bank’s baseline projection, commodity prices follow the path of market-implied futures prices for six months, and then flatline after that. But if natural gas prices were to follow the market-implied price for the entire period, then they would fall further, the decline in GDP would be -1.5% (rather than -2.1%) and unemployment would rise to 5.1% instead of 6.3%.

Following this meeting, markets think there is good chance of a further two large interest rate hikes (0.5% each) in the UK, followed by a good chance of two smaller hikes (0.25% each). That would leave rates peaking at around 3% by February next year.

The Treasury takes a loss

Gilts bought through the BoE’s asset purchases peaked at £875bn in December. They have since declined to £844bn, as the Bank has not been reinvesting maturing proceeds of these holdings. On Thursday, the MPC announced that it would start actively selling gilts at a pace of £10bn per quarter after its September meeting, subject to economic and market conditions being judged as appropriate.

The difference between a bond which is redeemed naturally and one that is sold due to interest rates rising sharply is that the former would generate a profit, whereas the latter would crystalise a loss. The sum of these profits and losses is ultimately owed to the Treasury, therefore outright sales reduce the government’s spending. From an economist’s perspective, a bit more fiscal tightening helps the fight against inflation. That explanation may not resonate with the average taxpayer who faces 13% inflation this winter.

Pelosi takes a trip

Away from the mundane world of interest rates, US House speaker Nancy Pelosi’s travel itinerary was the biggest news of the week. The US has been deliberately ambiguous in its relations with China and Taiwan - acknowledging the mainland government

as the sole legal government in China while avoiding expressing an opinion on the sovereignty of Taiwan. China had been attempting to deepen its economic integration with Taiwan in the hope of achieving a diplomatic unification, but since 2016 those efforts have been undone by President TsaiIng-wen who has sought closer ties with the US and to reassert Taiwan’s independence. Suppression of democracy in Hong Kong has also damaged the pro-unification movement within Taiwan, raising the question of whether China would be prepared to try and achieve reunification by force.

Pelosi, who is currently third in the US presidential line of succession, is the highest-ranking US official to visit China in two decades. It comes after President Joe Biden seemed to confirm that the US would defend Taiwan militarily before his team walked back the remarks. Her visit prompted a show of force from China with military drills and missile tests. Tensions seemed to weigh on Asian markets and whilst most commentators do not believe either side would willingly engage in conflict, they fear that these exercises could lead to an accidental outbreak of hostilities.

Could the Fed take a break?

In more conventional economic terms, the most important question for markets is the rate at which US interest rates peak. We have seen some modest softening of the labour market, with a small decline in job openings reported for June and a continued upward drift in initial jobless claims. The falling oil price offers hope that inflation may have peaked. US gasoline consumption is back down to the abnormally low levels of 2020 when the economy was in lockdown. Two quarters of negative growth in the first half of 2022 hinted at recession, even if they were driven by inventory adjustments rather than weak final demand. Last week, the Federal Reserve had suggested that it would consider the evolution of economic data when setting interest rate policy. With the market expecting a recession, that seemed to imply that rates might be nearer their peak.

America takes a raise

This week, Fed speakers were keen to emphasise that despite all this they still anticipate further meaningful tightening. July’s non-farm payroll report showed they were right to do so. Yet again, employment was incredibly strong, with more than half a million new jobs created, and fewer people were tempted into the labour market, resulting in a lower participation rate and lower rate of unemployment. That suggests very little spare capacity (really none), implying a need for even higher interest rates, and is underlined by strong wage growth that will further support demand and keep inflationary pressures simmering.

The initial reaction from markets was to see weaker equities, a stronger dollar and higher bond yields. Market expectations of the next US interest rate decision (not until late September) are that rates will rise by 0.75% again, and reach more than 3.5% by the end of this year.

This is good news that policymakers and investors could both do without.