Monday digest

Posted 22 November 2021

Overview: Dollar strength and divergence caps a dull week for investors

Despite the negative news flow, be it COVID or politics, UK consumers are proving their resilience once again, with both October retail demand and domestic consumer sentiment pointing up. Perhaps the buoyant jobs market is encouraging people to be less concerned about inflationary pressures eating into their disposable incomes than some economists would expect, or it is equally possible that higher energy and food prices have not quite hit home yet.

Whatever the cause – and usually there are several – the UK encapsulates the enduring dispute over whether inflation is ‘permanent’ or ‘transitory’. The most recent Consumer Price Index (CPI) inflation readings of over 4% across Europe/UK and over 6% in the US seem to settle the argument in favour of ‘permanent, but the ‘transitory’ camp remains unconvinced. Given consumer demand should return as the pandemic turns endemic over the coming year, and that energy supply shortages are expected to ease by the energy sector itself, it is not too hard to see where camp ‘transitory’ is coming from. For us, we see inflation pressures as real and more longer lasting than anticipated, but we also expect many of the factors driving inflationary pressure now to reduce meaningfully over 2022. Capital markets appear to have a similar view, with market-derived inflation expectations elevated for the near term, but then trending lower for the longer term.

The big up move by the dollar on Friday morning which took place as Austria became the first European country to reimpose a full lockdown, in a bid to arrest the rapid increase in new COVID cases, seemed to confirm our suspicion that much of this unusual behaviour boils down to the pandemic. Since last year’s COVID waves, the recovery of western economies had been progressing in lockstep, but it seems this may be about to change as central banks start to diverge on their journey towards monetary normalisation. As always, short-term market movements do not make a trend, but continued dollar strength has the potential to slow the recovery more than is already priced in on the back of the existing headwinds. Not surprisingly then, that investors experienced another dull week in terms of market movements. While dull is perhaps no bad thing as we move towards the end of what has been a positive year for investors thus far, we would be saddened if we were robbed of the promise of the joy that the seasonal year-end ‘Santa Rally’ brings.

Low vaccination rates point to ‘lower for longer’ ECB interest rates 

Could we be headed for another bleak COVID-wrecked winter? That certainly looks the direction of travel in continental Europe. Rising case numbers in Germany and Switzerland, while Austria imposed another full national lockdown, have meant Europe is once again considered the COVID epicentre, leading to fears the ‘fourth wave’ will cause considerable damage both to public health and the economy. Last week, the World Health Organization (WHO) declared Europe the only region in the world where COVID-related deaths are still rising. The WHO also stated that of 3.3 million new infections recorded in its latest weekly report, 2.1 million came from Europe. It also warned of another 500,000 more COVID-related deaths by February if urgent actions are not taken on the continent.

So, restrictions are back on the agenda across many European nations, and curtailing the movement of the unvaccinated is the focus of attention. Over the weekend, tens of thousands of protesters gathered in Vienna after the Austrian government announced a new lockdown and said vaccines would be made compulsory next year. Austria has a relatively low vaccination rate of roughly 65% of its total population (Germany’s vaccination rate is a similarly unimpressive 67.3%, which is particularly poor when contrasted with the UK’s 79.8% vaccination rate for everyone over the age of 12). In France, more than 20,000 new confirmed cases on Wednesday saw its health minister warn that the country’s own fifth COVID wave was picking up speed. The UK, by contrast, continues to see 35,000-40,000+ new COVID cases per day, but has ruled out mandatory jabs, having seen fatalities remain at levels comparable to autumn flu waves.

A redoubled effort to provide the vaccinated with a top-up looks like one of the best ways of preventing further national lockdowns and minimising further economic disruptions. Last week, the euro slipped to its lowest level in 16 months versus the Dollar as investors came to terms with the idea that policy divergence – with the European Central Bank (EBC) on one side and the Bank of England (BoE) and the US Federal Reserve (Fed) on the other – looks inevitable. While the BoE and Fed appear on course to lift interest rates over the next year, the ECB has stayed steadfast in its belief that accommodative policies are the right approach. But the ECB can point to a couple of key factors that make its decision to remain accommodative look the right call. For one, while Eurozone consumer prices have also accelerated – reaching a 13-year high of 4.1% in October – they are still not running as hot as in the US. And while Fed policy guidance continues in a more hawkish direction, the ECB must avoid any misstatements that could trigger a rise in borrowing costs for more heavily indebted nations such as Italy. Moreover, ECB President Christine Lagarde’s insistence that tighter monetary policy for the Eurozone would do more harm than good appears to be getting through – markets are now pricing in just a ten basis points rate rise in early 2023.

Even so, December’s ECB meeting, where it is due to update its inflation forecasts through to 2024, will be keenly watched, with traders listening out for hints that suggest the asset purchase programme will end in March, which may indicate that interest rate rises could yet happen sooner. For now, much depends on whether EU member states get their COVID case numbers under control. It is becoming clear that tolerance for those who remain vaccine-hesitant is diminishing. But with most people willing to take up vaccine top-ups, and with a new COVID treatment soon to be available in pill form, conditions should improve in the longer-term, even if the run-up to Christmas holds fewer good tidings.

Will banks be the comeback stars of 2022?

Inflation continues to dominate headlines and has left market participants debating a plethora of topics, including the nature of ‘transitory’ or ‘structural/permanent’ inflationary pressures, what it means for the subsequent size and speed of interest rate increases, how far bond yields can continue to rise, and whether yields are reflecting the potential for central bank policy error.

Amid the fear and uncertainty, there is one sector that logically looks set to be a beneficiary of the new changing environment. We are referring to the financials sector, and banks in particular. Banks suffered for several reasons as the pandemic hit, including the perception they would struggle to receive interest payments on loan books as companies were unable to trade and shut down. Regulators also dampened investor appetite for banks by forcing them to curtail dividends and share buybacks. However, those restrictions have been lifted, and fears over loan losses have also dissipated as default rates have kept surprisingly low, thanks to the exceptional bridging support provided by governments.

From here, banks appear well-placed to become beneficiaries from gradually rising interest rates. Indeed, in the UK, we have already seen banks start to raise mortgage rates in anticipation of the first BOE interest rate hike now expected before the end of the year. Also, given the change in funding structure, where banks have benefited from robust cash deposit growth – which is often non-interest bearing – the opportunities for this sector are arguably even greater than in the past. The change in funding structure has been reflected in bank loan/deposit ratios. In the US, this ratio has fallen to 63% from 77% in 2019. If higher interest rates can then be applied, banks’ earnings are likely to see a significant pick-up.

This view applies primarily to developed markets. Within emerging markets, banking exposure is currently tainted with ongoing friction in China’s property development sector. Beyond the emerging market perspective, another word of caution would be that should central banks tighten too quickly and too far – by raising interest rates rather than tapering its bond buying programmes, then even the appeal of this sector would wane.  But at this point of the economic cycle, as we are about to embark on a trend of rising interest rates and bond yields, the banking sector provides a good example – and a reminder – that some inflation and gradually rising interest rates is not something to be feared, and is a necessary step on the path to economic recovery.

Subscribe to the Tatton Weekly Email

Get the latest news from Tatton HQ directly into your inbox every week. Packed with industry insights, our weekly mailing will keep you informed on the latest news from Tatton and beyond.

You can unsubscribe at any time by clicking the link in the footer of our emails. For information about our privacy practices, please click here.

We use Mailchimp as our marketing platform. By clicking below to subscribe, you acknowledge that your information will be transferred to Mailchimp for processing. Learn more about Mailchimp’s privacy practices here.

Important notice:

The Tatton Weekly is provided for information purposes only and compiled from sources believed to be correct but cannot be guaranteed.  It should not be construed as an offer, or a solicitation of an offer, to buy or sell an investment or any related financial instruments. Any opinions, forecasts or estimates constitute a judgement as at the date of publication and do not necessarily reflect the views held throughout Tatton Investment Management Limited (Tatton). The Tatton Weekly has not been prepared in accordance with legal requirements designed to promote independent investment research. Retail investors should seek their own financial, tax, legal and regulatory advice regarding the appropriateness or otherwise of investing in any investment strategies and should understand that past performance is not a guide to future performance and the value of any investments may fall as well as rise and you may get back less than you invested.

Any reader of the Tatton Weekly should not use it as a guide or form the basis of a decision relating to the specific investment objectives, financial circumstances or particular needs of any recipient and it should not be regarded as a substitute for the exercise of investors' own judgement or the recommendations of a professional financial adviser. The data used in producing the Tatton Weekly is for your personal use and must not be reproduced or shared.

Please select all the ways you would like to hear from Tatton Investment Management: