Monday digest

Posted 11 July 2022

Overview: Markets not yet reflecting broader public fears
The murder of past Japanese Prime Minister Abe is a reminder of how much we should value our public servants and politicians. We should be grateful that they are prepared to do a job we need so much. Whether they are exercising high office or merely representing us, they are invested with great expectation, much responsibility but little immediate power to meet those expectations.

The sad news from Japan compounded what was a politically turbulent week, both here in the UK and internationally. However, against this background, markets were benign. In the UK, it felt like market moves were linked to ructions in the Cabinet. However, sterling fared better through the week than the euro. Fears for Europe continue to worsen, driven by the current awful situation surrounding European energy prices. Two weeks ago, we pointed out how Europe’s gas and electricity prices had surged, especially for contracts covering this coming winter. Last week, the price situation worsened, which led to both French and German governments stepping in to save energy distributors. The German energy distributor-generator Uniper will be rescued with a government package, probably of around €8-9 billion. The rescue will potentially involve the German government taking an equity stake but also lending the company most of the proceeds (in the same manner as happened for Lufthansa during the pandemic – the government got its equity stake at a discount to the market price at the time).

It may not solve the problem in terms of generating enough electricity. Russia is constraining gas supplies, but France’s problems revolve around the lack of rainfall in the Alps and poor maintenance over many years. The drought has brought river levels to very low levels and those rivers are used as the cooling water supply for EDF’s old nuclear reactors. Output is the lowest in 30 years. Elsewhere, Bloomberg reported on 2 July that “Italy is set to spend almost 40 billion euros subsidising energy bills for consumers, while the UK put down some £37 billion to ease the impact on consumers. The nationalisation of Bulb alone will cost consumers about £2.2 billion”. For markets however, the issue is whether businesses, especially manufacturers will be immunised. Most are currently forced to pay market rates. As we mentioned last week, manufacturers average energy proportion of overall costs in 2019 was about 12%. This winter, electricity will be around four times that price. So, even if consumers are not hit directly by electricity price rises, they will face further inflation in goods. Businesses will likely see sales volumes decline. That would mean a Europe-wide recession, an outcome now clearly being priced by markets.

However, there is some good news coming from markets. The fall in bond yields (both fixed and ‘real’) is not surprising given the context, but provides some respite. More surprising perhaps is that general credit spreads are finishing the week broadly unchanged after spiking higher midweek. They’re still signalling a recession, but the government actions are giving hope that a pandemic-like response for businesses is in the offing. Meanwhile, the declines in industrial metal and agricultural commodity prices are alleviating some inflationary concerns. Risk assets in the US are stabilising as well following the sharp downswing in longer-dated bond yields. While the move came about because of growth concerns, it also seems a number of investors have bought back into bonds after being considerably underweight for a long period. Credit spreads also came down quite sharply, about 0.1% in yield falls for investment-grade credits. Also on a positive note, China is stepping up its fiscal push into the autumn with about $220 billion of  new credit being raised by local governments. The swing-round in growth in China following the lockdowns has been as strong as could possibly been expected, and is set to go further. At this rate China may well reach the 5.5% yearly growth target for 2022 despite running at a near 10% annualised decline for the second quarter.

Market sentiment will depend greatly on the outturn for Europe. The Nord Stream pipeline annual maintenance shutdown finishes on 21 July and investors will be hoping Gazprom will resume a full supply after the unscheduled reductions that began in June. However, this week, French and German government willingness to step in to bail out the energy companies and protect consumers and businesses has certainly helped. As long as investors (and perhaps the European Central Bank) are willing to fund the increase in debt, Europe may be able to see this through without devastating economic damage.

UK government staggers on – but markets only shrug
As the working week starts, Boris Johnson is still Prime Minister in name if not in substance. The slow-motion collapse of the Conservate Party has become a psychodrama of the highest degree. A paralysed government is clearly a serious issue at any time. When inflation is rampant and real economic growth has deteriorated, one might expect it to be the worst possible time. And yet, capital markets barely registered the move.

A simple rationalisation might be that Johnson’s demise has long been telegraphed, and so former allies finally gathering for his execution is not big news. Last month’s narrow win in the vote of no confidence never really felt like a victory, and the writing has not so much been on the wall as all over the national news. While markets once evaluated Britain’s prospects by the relative hardness of its Brexit and its likely impacts, there is a sense now that the damage has already been done. The UK has the highest inflation rate in the G7 and one of the worst growth outlooks. Although energy and commodity price rises are not the fault of the UK severing ties with the European Union (EU), frictions with our largest trading partner have exacerbated the global supply chain issues.

Last week, the Bank of England (BoE) issued yet another dire warning on economic prospects. According to Governor Andrew Bailey, “Since the last financial stability report, the global economic outlook has deteriorated markedly”. Deterioration now seems to be a trend in BoE guidance, with recession either looming or already underway. So, there is a sense that change of government either will not or cannot change much about the near-term situation. Whoever ends up in charge of the Treasury come Autumn will likely want to bring in further tax cuts – but the space to do so has arguably already been exhausted by Sunak. Beyond which, any new measures will likely have minimal impact. While a full-scale loosening of fiscal policy anytime soon is unlikely, it is by no means out of the question – particularly given the uncertainty over who might end up at Number 10. That would force the BoE into more short-term interest rate hikes than currently priced (the market now expects another 0.75% over the next three meetings). While the sum of the fiscal easing and monetary tightening may end up being neutral for the UK economy, retail banks are tightening up loans against worsening balance sheets, and this would probably not help.

For almost all of the last century the UK benefitted from a positive flow of investment income. Our stock of overseas assets brought in more than we paid out on our liabilities. Now, in addition to a buying more goods and services than we sell abroad, we have to pay out interest and dividends. This introduces a huge risk to financial stability, as a sudden flight of capital would leave the system exposed. More inflation and a widening government deficit could trigger such an exodus. Moving “beyond Brexit” is critical to the UK’s prospects, but few think a new Conservative leader can. That is why are keeping an eye on the incoming government’s fiscal policy. We do not expect it to materially affect the UK’s position, but there is a tail risk that cannot be ignored. For sterling, this is balanced against the short-term upward pressure it could bring from a more aggressive BoE. All in all, the risks are finely balanced, if a little uncomfortable. The muted currency market response to this week’s chaos is therefore perhaps fitting.