Monday digest

Posted 13 June 2022

Outlook: new worries, old concerns?
After renewed positive sentiment in recent weeks, markets once again are showing signs of fragility. We could characterise this ‘risk off’ mood as growth scepticism or more wariness that inflation needs even stronger and swifter central bank policy tightening before being squeezed out. Last week’s change in emphasis from the European Central Bank (ECB) – while expected – provided the necessary headlines. Interest rates were unchanged, but ECB President Christine Lagarde “committed” that rates will rise by 0.25% at the July meeting, and that bond buying will also end (although there was no mention of actual bond sales). From the current overnight market rate of -0.5%, most economists expect the year-end traded rate to be around +0.75%.

If the ECB is so certain of a rate hike next month, why not start now? If the ECB’s own inflation forecasts keep going up – and all the risks lie towards higher inflation – this is like driving towards a cliff edge with a broken speedometer and promising your passengers you won’t brake too sharply. There may be reasons to think the ECB’s laggardly stance (pun intended) is intentional because most believe the underlying issues are ‘global cost push’, and that the policy that matters comes from the US Federal Reserve (Fed). In which case, policy compression is already underway. US inflation data for May released on Friday worried some investors by being slightly above expectations (with monthly core consumer price index (CPI) inflation still rising at an annualised rate of 7%). US ten-year Treasury yields returned to above 3% last week. Perhaps investors are yet to be convinced inflationary pressures may have peaked.

The current upswing in market risk premia seems to us to be more of a straightforward tale of risk aversion. If energy prices keep rising, or some other external threat emerges, those more anxious investors who headed for the exit might been justified. But resilience levels and activity potential for the global economy have not been in as promising a state for a long time – as has been the resilience of systemically important financial institutions. We suspect last week’s wobble was no more than that.

Monetary and fiscal policy: giving with one hand, taking with the other
Boris Johnson’s pyrrhic victory on Monday’s ‘no-confidence’ vote could have big implications for the UK economy. Not that you could tell from the market reaction: the FTSE 100 dropped ever so slightly in midweek, while sterling stayed at the same dollar value. But the Prime Minister’s weakened position makes him much more amenable to the whims of his colleagues, and the pressure to ease the UK’s tax burden is mounting. Backbench MPs are reportedly urging the Prime Minister to override the Treasury on cutting taxes, regardless of the inflationary impact. If this happens, it is unlikely to be matched by spending cuts, which could threaten another rebellion. As such, we should expect that the government will loosen fiscal policy in the coming months.

Let that sink in for a moment. Britain is currently seeing its highest inflation levels in 40 years – higher than any other G7 nation – and unemployment is the lowest it has been since the 1970s. Energy and goods supply is severely constrained, and with an excruciatingly tight labour market, we are on the cusp of a wage-price spiral. And amid all of this, the government is throwing more fuel on the fire by loosening fiscal policy. As politically and socially understandable as this may be, such a move would increase inflationary pressures and put the Bank of England (BoE) in a bind. In this environment, monetary policymakers cannot afford to balance growth prospects against price stability. Instead, they must tighten policy hard, raising interest rates and likely choking off growth potential.

This combination of tight monetary and loose fiscal policy is far from confined to the UK either, as the ECB announcement made clear. More generally, it is a reversal of the policies promoted for more than a decade after the global financial crisis. In that time, we have seen incredibly easy financial conditions while governments have been reluctant to loosen the public purse-strings and in many cases applied outright fiscal austerity. Over the years, many called on politicians to match central banks’ largesse,  that it is happening now – while global inflation surges – will no doubt make many uncomfortable.

Rising interest rates and central bank tapering puts upward pressure on yields. But so too does loose fiscal policy, as higher government borrowing increases the bond supply competing for investor’s buying interest. Both happening at the same time could mean dramatic upward pressure on yields – which is unlikely to stop anytime soon. Rising bond yields also push up borrowing costs for consumers and businesses. If these increase too rapidly, widespread defaults become much more likely – the classic harbinger of recession. The silver lining is that increased borrowing costs act as a dampener on demand, pulling down inflation and lessening the need for higher interest rates. Yields are pushing up from extraordinarily low levels, so there could still be some way for bond yields to go before there is a significant risk of triggering a debt default cycle.

The BoE will certainly hope that is enough to tame price rises. With the UK economy forecast  to be the second-worst performing in the G20 (behind only sanction-ravaged Russia) tighter monetary policy could mean severe pain for businesses and consumers. But with the government apparently pushing ahead with fiscal aid, the central bank has little choice. What the new policy mix means over the longer-term remains to be seen.

A fistful of chips: from supply shortage to glut
US technology giant Intel took a beating from investors last week, leading to a 5.3% fall in its share price on Wednesday. This came after projecting disappointing results for the second quarter. Intel reckons its profits will be around 70 cents a share, well below analyst estimates of 82 cents, and follows a disappointing first quarter of 2022, which saw falling revenues for its PC microchips. Intel’s management insists decent growth forecasts for 2022 will be achieved, implying a stronger second half than previously expected. Investors are not so sure that optimism is warranted, unnerved by signs of faltering demand for PCs – Intel’s largest revenue source.

Of the other global chip manufacturers, NVIDIA has had a harder time this year whereas Taiwan Semiconductor Manufacturing Co (TSMC), the world’s most valuable chip maker, expects revenues to grow 30% overall this year, a jump from the near 25% growth of last year. TSMC’s projections seem at odds with actual chip price moves, and concerns that demand for computer chips is stalling from global economic and political factors: war in Ukraine, Chinese lockdowns and the cost-of-living crisis across the developed world. Last year, waiting times for games consoles and new cars were unheard of all over the world. TSMC claim these supply shortages continue.

Wait times for semiconductor delivery hit a record high in May, and chipmakers are raising prices due to rising costs, but in other respects, the chip shortage seems much less pronounced. Companies in need of chips are reportedly starting to see relief and, more importantly, demand has plateaued. Apple, one of TSMC’s best customers, is planning to keep its production of iPhones flat in 2022 – capping off a potential route for growth. This comes as global growth is slowing significantly and inflation is eating into consumers’ disposable incomes. Rapid price rises have also forced the hands of central banks, which are now tied into a rate-hiking cycle that will result in higher borrowing costs and less available capital. The smartphone industry has struggled with these headwinds all year, but the pressures are broad-based, hitting demand for goods well beyond consumer electronics.

Therefore, despite manufacturer claims to the contrary, capital markets clearly believe chip demand is weaker than supply. Where once there was extreme undersupply, stock markets indicate there is now oversupply. This looks unlikely to change anytime soon, either. Slowing global growth and a cost-of-living crisis will hold back demand in the short term. And over the medium term, there are signs that supply will be boosted. Beyond the question of how we look at chip manufacturers from an investment perspective, the other takeaway from the easing of chip supply is perhaps this: just as chip shortages were the first sign last year of building supply chain disruptions, the easing of supply issues for ‘commoditised’ semiconductor chips now may well mean that price pressures from the supply shortage of goods might be behind us soon.

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