Monday digest

Posted 28 March 2022

Overview: A good week for global equities, less so for global bonds
For much of this year, falling bond prices (and higher bond yields) have been associated with weaker equity markets. Bond investors will have taken little comfort

For much of this year, falling bond prices (and higher bond yields) have been associated with weaker equity markets. Bond investors will have taken little comfort that equities bucked the trend last week and finally did well while bonds fell. In the broadest sense, the US Federal Reserve (Fed) said interest rates will need to go higher, and US Treasury yields have risen rapidly as a result. Not all bonds fared badly, however. Corporate bonds have had a hard time in recent months, as credit spreads and underlying yields have both risen. However, last week, credit spreads declined, in line with equity risk premia. In other words, equity valuations got a bit more expensive. Indeed, the three-month rolling correlation between bond prices and equity prices recently became positive, which is a rare occurrence (there have been only short periods when bonds and equities have been positively correlated). However, the rise in global bond yields does give room for bonds to provide a cushion should economic growth falter again.

A decline in the pricing of risk perhaps goes hand-in-hand with the feeling that geopolitical risks on resource prices have lessened. We have observed before that the start of a major conflict has often marked the point where the associated risks are mostly priced into markets. Equity markets have tended to perform well in the months afterwards, even if the conflict continues. In the case of Russia’s invasion of Ukraine, there are still several potential areas that could spell a resurgence of risks. However, strong and concerted policy efforts to contain the conflict’s impacts on energy prices are bearing some fruit. Last Friday saw European natural gas prices fall more than 10% following a deal between the US and the European Union (EU) to boost the supply of American liquefied natural gas. Holding back energy prices from another destabilising bout of price rises is extremely important for markets, but even if energy prices stabilise, it is unclear whether central bank inflation-fighting work is done.

The good news is that during the past few months, equity markets have built up quite a lot of risk premia which can buffer the impact of rate rises. It remains to be seen how markets will react if rate expectations rise high enough to start to hurt the growth outlook. Or in other words, how long it will be until good news is once again at risk of turning into bad news for markets.

Was the Bank of England the only fan of Sunak’s Spring Statement?
Rishi Sunak’s Spring Statement unravelled rather quickly. The Chancellor talked up the 5p per litre cut to fuel duty with the fervour of a vegetable market stallholder (By contrast, Germany just slashed a litre of petrol by 30 cents), as he did with the rise in the National Insurance Contributions threshold. In truth, there were few new measures revealed – and even fewer that will have any short-term impact. The Chancellor insisted that the £3,000 bump in the National Insurance threshold will cancel out his previously announced 1.25% rise in contributions for 70% of workers. But his claim that this amounts to “the biggest net cut in personal taxes in over a quarter of a century” was roundly rejected by both the Resolution Foundation and the Institute for Fiscal Studies. According to the latter, most households will be 4% worse off in real terms, while the poorest households will be 6% worse off after inflation.

Moreover, there was no increase to Universal Credit, meaning that the unemployed, students (facing higher loan repayments) and those on fixed income pensions will not receive comparable help. The cut to fuel duty underlines this distinction, as does the focus on “working families”. Coming against the backdrop of the highest levels of inflation in decades (now at 6.2%) most citizens face a dramatic fall in discretionary spending power. The Office for Budget Responsibility (OBR) estimates real household disposable incomes will fall by 2.2% this year, the biggest drop since records began in 1956.

The Chancellor has long argued for fiscal restraint, reportedly insisting on tax rises even as Boris Johnson considered scrapping them some months ago. Last week’s Statement was full of tax-cutting rhetoric, but the fiscal hawkishness ultimately shone through. The Treasury is continuing with fiscal tightening that began towards the end of last year, unaffected by the economic woes buffeting Britain. This was certainly the view of bond markets, where the UK inflation break-evens moved down last week – meaning in this context less predicted economic growth.

Central banks around the world have begun a sharp tightening cycle and, last year, the Bank of England (BoE) was at the forefront of this tightening, rising interest rates in December and signalling that further hikes would be needed. Indeed, it followed this up with another rate rise earlier this month, leaving benchmark interest rates at 0.75%. Over time, though, the market-implied outlook for future monetary policy has softened. Markets no longer expect that the BoE need be as hawkish in taming inflation as the US Federal Reserve. But the BoE’s outlook has softened because of Britain’s tight fiscal situation. Fiscal drag from the Treasury will act as a dampener on demand, reducing the overall demand-driven inflation pressure in the UK. This makes the inflation-fighting job easier for the BoE, thereby allowing policymakers to signal a lower path for future interest rates.

A more accommodative BoE is also a positive for growth, but this is balanced against the negative impacts of fiscal and energy price drag. However the Chancellor tries to package this Spring Statement, it revealed a tighter fiscal stance ahead. While that might help contain inflation pressures, it will almost certainly do the same to growth.

Central bank tightening: echoes of the 70s?
Amid soaring global inflation, historical comparisons are increasingly commonplace, with pundits pointing to immense supply-side shocks and dwindling growth prospects echoing the 1970s. ‘Stagflation’ – the unusual cocktail of rapidly rising prices and weak growth – has crossed the boundary from financial to popular news, prompted by the looming cost of living crisis. We certainly expected a softer landing earlier in the year, as supply-chain bottlenecks appeared to be easing and the worst of Covid disruptions seemed well and truly behind us. But Russia’s invasion of Ukraine changed the picture dramatically – as energy shortages and spiralling prices now dominate the agenda.

Central banks across the world are committed to containing runaway prices. But while almost all monetary policymakers are working to tame inflation, there are differences in how they do it. In the US, the Fed is on an aggressive path, not only raising interest rates another 0.25% at its most recent meeting, but with Fed chair Jay Powell significantly more hawkish in his rhetoric afterwards. Goldman Sachs predicts that faster rate rises will occur in May and June, followed by seven quarter-point hikes leading up to the third quarter of 2023. That would put the Fed’s benchmark rate at 3-3.25% by the end of next year. Powell no doubt recognises that current inflation is due to a variety of supply problems, which tend to be short term and not endemic, but likewise acknowledges the risk of allowing them to have a longer-term impact on inflation expectations. The aim is to nip the problem in the bud, rather than let it fester.

As already noted, UK fiscal policy is distinctly tighter than developed market peers, thereby giving the BoE room to stay loose. The European Central Bank (ECB) is in a different position. While it plans to exit its accommodative stance, it is significantly behind the Fed in its timeline, and only expects to stop its asset purchases in Q3, before pursuing a first rate hike sometime after. The main question for ECB policymakers seems to be whether that is too much, rather than too little. Europe was in a weaker position than the US generally, but Russia has presented a particular problem. War in Ukraine will likely significantly hit European demand, and as such, it should not be a surprise should the ECB’s rate rising to be delayed. On the other hand, policymakers will be aware of the danger the cost shock could have, particularly if demand fares better than expected and inflation expectations become embedded. As such, the ECB’s policy deliberations are still finely balanced.

The world’s central banks are tightening policy with varying degrees of vigour – but all are unmistakably tightening. The immense cost shock we are living through forces their hand in this regard. Central bankers seem determined to avoid another 1970s. However, even though tightening should deal with the spectre of stagflation, it is nevertheless an inhibitor to medium-term growth by way of demand destruction. At the moment, it is not yet clear whether investors have woken up to that or whether they believe central banks will blink at the very last minute.

that equities bucked the trend last week and finally did well while bonds fell. In the broadest sense, the US Federal Reserve (Fed) said interest rates will need to go higher, and US Treasury yields have risen rapidly as a result. Not all bonds fared badly, however. Corporate bonds have had a hard time in recent months, as credit spreads and underlying yields have both risen. However, last week, credit spreads declined, in line with equity risk premia. In other words, equity valuations got a bit more expensive. Indeed, the three-month rolling correlation between bond prices and equity prices recently became positive, which is a rare occurrence (there have been only short periods when bonds and equities have been positively correlated). However, the rise in global bond yields does give room for bonds to provide a cushion should economic growth falter again.

A decline in the pricing of risk perhaps goes hand-in-hand with the feeling that geopolitical risks on resource prices have lessened. We have observed before that the start of a major conflict has often marked the point where the associated risks are mostly priced into markets. Equity markets have tended to perform well in the months afterwards, even if the conflict continues. In the case of Russia’s invasion of Ukraine, there are still several potential areas that could spell a resurgence of risks. However, strong and concerted policy efforts to contain the conflict’s impacts on energy prices are bearing some fruit. Last Friday saw European natural gas prices fall more than 10% following a deal between the US and the European Union (EU) to boost the supply of American liquefied natural gas. Holding back energy prices from another destabilising bout of price rises is extremely important for markets, but even if energy prices stabilise, it is unclear whether central bank inflation-fighting work is done.

The good news is that during the past few months, equity markets have built up quite a lot of risk premia which can buffer the impact of rate rises. It remains to be seen how markets will react if rate expectations rise high enough to start to hurt the growth outlook. Or in other words, how long it will be until good news is once again at risk of turning into bad news for markets.

Was the Bank of England the only fan of Sunak’s Spring Statement?
Rishi Sunak’s Spring Statement unravelled rather quickly. The Chancellor talked up the 5p per litre cut to fuel duty with the fervour of a vegetable market stallholder (By contrast, Germany just slashed a litre of petrol by 30 cents), as he did with the rise in the National Insurance Contributions threshold. In truth, there were few new measures revealed – and even fewer that will have any short-term impact. The Chancellor insisted that the £3,000 bump in the National Insurance threshold will cancel out his previously announced 1.25% rise in contributions for 70% of workers. But his claim that this amounts to “the biggest net cut in personal taxes in over a quarter of a century” was roundly rejected by both the Resolution Foundation and the Institute for Fiscal Studies. According to the latter, most households will be 4% worse off in real terms, while the poorest households will be 6% worse off after inflation.

Moreover, there was no increase to Universal Credit, meaning that the unemployed, students (facing higher loan repayments) and those on fixed income pensions will not receive comparable help. The cut to fuel duty underlines this distinction, as does the focus on “working families”. Coming against the backdrop of the highest levels of inflation in decades (now at 6.2%) most citizens face a dramatic fall in discretionary spending power. The Office for Budget Responsibility (OBR) estimates real household disposable incomes will fall by 2.2% this year, the biggest drop since records began in 1956.

The Chancellor has long argued for fiscal restraint, reportedly insisting on tax rises even as Boris Johnson considered scrapping them some months ago. Last week’s Statement was full of tax-cutting rhetoric, but the fiscal hawkishness ultimately shone through. The Treasury is continuing with fiscal tightening that began towards the end of last year, unaffected by the economic woes buffeting Britain. This was certainly the view of bond markets, where the UK inflation break-evens moved down last week – meaning in this context less predicted economic growth.

Central banks around the world have begun a sharp tightening cycle and, last year, the Bank of England (BoE) was at the forefront of this tightening, rising interest rates in December and signalling that further hikes would be needed. Indeed, it followed this up with another rate rise earlier this month, leaving benchmark interest rates at 0.75%. Over time, though, the market-implied outlook for future monetary policy has softened. Markets no longer expect that the BoE need be as hawkish in taming inflation as the US Federal Reserve. But the BoE’s outlook has softened because of Britain’s tight fiscal situation. Fiscal drag from the Treasury will act as a dampener on demand, reducing the overall demand-driven inflation pressure in the UK. This makes the inflation-fighting job easier for the BoE, thereby allowing policymakers to signal a lower path for future interest rates.

A more accommodative BoE is also a positive for growth, but this is balanced against the negative impacts of fiscal and energy price drag. However the Chancellor tries to package this Spring Statement, it revealed a tighter fiscal stance ahead. While that might help contain inflation pressures, it will almost certainly do the same to growth.

Central bank tightening: echoes of the 70s?
Amid soaring global inflation, historical comparisons are increasingly commonplace, with pundits pointing to immense supply-side shocks and dwindling growth prospects echoing the 1970s. ‘Stagflation’ – the unusual cocktail of rapidly rising prices and weak growth – has crossed the boundary from financial to popular news, prompted by the looming cost of living crisis. We certainly expected a softer landing earlier in the year, as supply-chain bottlenecks appeared to be easing and the worst of Covid disruptions seemed well and truly behind us. But Russia’s invasion of Ukraine changed the picture dramatically – as energy shortages and spiralling prices now dominate the agenda.

Central banks across the world are committed to containing runaway prices. But while almost all monetary policymakers are working to tame inflation, there are differences in how they do it. In the US, the Fed is on an aggressive path, not only raising interest rates another 0.25% at its most recent meeting, but with Fed chair Jay Powell significantly more hawkish in his rhetoric afterwards. Goldman Sachs predicts that faster rate rises will occur in May and June, followed by seven quarter-point hikes leading up to the third quarter of 2023. That would put the Fed’s benchmark rate at 3-3.25% by the end of next year. Powell no doubt recognises that current inflation is due to a variety of supply problems, which tend to be short term and not endemic, but likewise acknowledges the risk of allowing them to have a longer-term impact on inflation expectations. The aim is to nip the problem in the bud, rather than let it fester.

As already noted, UK fiscal policy is distinctly tighter than developed market peers, thereby giving the BoE room to stay loose. The European Central Bank (ECB) is in a different position. While it plans to exit its accommodative stance, it is significantly behind the Fed in its timeline, and only expects to stop its asset purchases in Q3, before pursuing a first rate hike some time after. The main question for ECB policymakers seems to be whether that is too much, rather than too little. Europe was in a weaker position than the US generally, but Russia has presented a particular problem. War with Ukraine will likely significantly hit European demand, and as such, it should not be a surprise should the ECB’s rate rising to be delayed. On the other hand, policymakers will be aware of the danger the cost shock could have, particularly if demand fares better than expected and inflation expectations become embedded. As such, the ECB’s policy deliberations are still finely balanced.

The world’s central banks are tightening policy with varying degrees of vigour – but all are unmistakably tightening. The immense cost shock we are living through forces their hand in this regard. Central bankers seem determined to avoid another 1970s. However, even though tightening should deal with the spectre of stagflation, it is nevertheless an inhibitor to medium-term growth by way of demand destruction. At the moment, it is not yet clear whether investors have woken up to that or whether they believe central banks will blink at the very last minute.

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