Monday digest

Posted 17 July 2023

Overview: Core inflation slowdown equals upbeat equity markets
We wrote at the end of last week that markets were still absorbing the prospect of another round of significant interest rate rises from central banks, and that equities would therefore come under further pressure. But by the end of last week equity markets had risen sharply, with most more than reversing their losses of the previous week. The catalyst for the US stock market rally was the release of the latest consumer price index (CPI) figures, which showed that core inflation (with energy and food stripped out) cooled to 3% in June, the lowest rate of growth in two years.

Greedflation or wage-price spiral?
Probably not since the 1970s has inflation been such an all-consuming topic in public discourse. This is because, of course, for decades there was very little of it. Things could hardly be more different now. People are clearly worried about rising prices for goods and services, and what might happen to their individual or collective spending power. But beyond that, there is a deep argument raging about what causes inflation. Opinions remain divided across two major camps: those who think corporate ‘profiteering’ is to blame for runaway prices, and those who think wages are the main cause. As you might imagine, the dividing line is highly political. Here in the UK, the Bank of England (BoE) is adamant wages are the biggest inflationary concern, whereas in Europe, policymakers are much more concerned about corporate profits. Last week, BoE Governor Andrew Bailey joined Chancellor Jeremy Hunt in calling on Britons to show restraint in their wage demands. This is his second intervention, having called for similar restraint back in March. At the same time, Hunt reportedly asked the BoE to scrutinise profits in the UK food industry, following accusations of ‘price gouging’ (the British Retail Consortium recently revealed food prices increased 14.6% in the year to June).

Unfortunately, it is almost impossible to objectively say whether profits or wages are the bigger inflationary force, because they are two sides of the same economic coin. There has been a lot of talk recently about the return of labour pricing power – particularly after two years of widespread industrial action. In this sense, the sensitivity of inflation to employment has increased, which the BoE clearly sees as its main way of impacting the economy. But one could just as well argue there has been a return of corporate pricing power, following a long period of consolidation across nearly every major industry. This has led to wages and profits feeding off each other without either backing down – what should perhaps be called the ‘wage-profit spiral’. Who should ‘give in’ first is a political issue but, unless somebody does give in, we will keep talking about inflation for some time to come.

Banking sector pressure appears far from over
Last Wednesday, BoE Governor Bailey called on UK banks to pass along higher interest rates to savers. Over the past year-and-a-half, interest rates have seen the sharpest spike in a generation, going from near zero at the end of 2021 to 5% now, with further hikes set to come. But deposit interest rates from the big retail banks remain at little over 1% in many cases. UK retail banking suffers from a notable lack of competition, being largely dominated by older, established players and building societies. This means savers have few options and have to take whatever rate is offered, as regulators point out, however, both the government and the BoE have been complicit in reducing the number of British banks, leading to the concentrated environment we see today.

The situation is notably different in the US and Europe, where smaller regional banks are much more prominent. But the prominence of regional banks in the US has been much discussed this year after many of them collapsed, most notably Silicon Valley Bank (SVB), bringing to light deeper structural problems. Having many smaller players increases competition and should benefit customers. But for the banks themselves, the lack of scale and the fact their lending and borrowing all happen in relatively small regions, substantially decreases the potential for diversification. As investors know, a lack of diversification can mean losses piling up quickly. That is exactly what happened to SVB, and these problems have not gone away for the regional banks.

A difficult financial and economic climate is toughest for smaller businesses. For banks specifically, tightening financial conditions can boost profitability if it means higher long-term lending rates over short-term deposits (as seen in the UK), but it can also threaten liquidity, something smaller players inevitably have less of. The incentive for mergers or acquisitions is therefore large. We suspect this is less likely to play out in Europe, where the structural barriers to cross-border mergers are higher. European banks tend to be well capitalised, so stormy conditions might not be a problem at first. But the combination of high interest rates for longer and smaller corporates suffering under the higher cost of borrowing could lead to banking stress and even defaults if the Eurozone economy takes a turn for the worse. Here in the UK, we seem not to have these problems, but a highly concentrated banking system has its drawbacks too. Political pressure is now being exerted on British banks, both by politicians and the BoE. If consolidation increases in the US, we should expect the same political problems to play out, and if the US is more active in its antitrust policies – as has often been the case historically – some of that pressure might make it over here too.