Monday digest

Posted 10 October 2022

Outlook: Reading the runes of October’s market bounce
As last week reminded us, volatile markets do not always swipe down, nor do they stay volatile forever. Monday and Tuesday saw a formidable ‘relief’ rally in global equities. Indeed, on Tuesday, US stocks recorded their biggest daily gain since 2020, leaving the S&P 500 up 5% by midweek. Stocks slid back toward the end of the week, but not by the same margin. Nor did they collapse after disappointing news of OPEC+ oil supply cuts. Indeed, the week felt like a microcosm of how the year has gone so far: down-trending capital markets ricocheting between recessionary fear and bear market rallies when hope takes hold that inflation is turning over.

There is much debate about whether a strong dollar causes weaker global growth, or is merely a sign of weak growth beyond the shores of the US economy. Historically, a strong dollar has coincided with weaker global trade, and while the rest of the world languishes, the US Federal Reserve (Fed)’s focus solely on domestic inflation pressures does very little to help the global economy. Last week’s comments from former Fed Chair Janet Yellen that talked of “global repercussions” to the Fed’s policies suggest the US is not totally unaware of its impact on international financial conditions.

Back to last week’s market action, the early-week positivity came perversely from news of weaker US employment data. US job openings fell by more than one million in August, the largest fall since the start of the pandemic. But, with the Fed still intent on crushing inflationary pressure by cooling wages, the bad news is good news as far as investors are concerned. The hope is that rising unemployment will give the Fed license to ease its grip, bringing the fabled ‘peak interest rates’ forward and setting the stage for looser financial conditions next year, as the Fed pivots away from raising rates further.

Another oil shock in the pipeline?
On Wednesday, OPEC+ countries – led by Russia and Saudi Arabia – agreed to cut output targets by two million barrels per day from November. That represents about 2% of global oil production and, coming in the middle of rapid inflation across the western world, parallels have been drawn to the devastating oil shocks of the 1970s. As well as raising oil prices, Wednesday’s announcement knocked equity markets down on the fear of higher fuel costs, inflation, and lower growth. But the two million barrels per day cut applies to previously agreed targets, rather than actual pumping volumes. Given the gap between what most countries can produce and what they are allowed to, the hit to supplies will be considerably less.

Crude prices above $100 per barrel would certainly bring unwanted inflationary pressure, but the likely increase is not so huge as to destabilise the world economy. Moreover, Saudi Arabia’s willingness to stick by Russia puts it on a political collision course with the US. We have already seen tensions between the Biden administration and the Kingdom’s Crown Prince, and further escalation could bring damaging uncertainties. One of the reasons for this is that the US arguably has the most to lose from higher oil prices. While Europe has struggled with natural gas supplies, its economy is much less sensitive to oil and refined fuel prices than the US, despite the latter’s access to shale production. American shale producers do not have the capacity to make up for global shortfalls or price jumps, particularly in light of President Biden’s shift towards renewable energy.

We don’t believe this drop in output is at the level of an oil price ‘shock’, but it could bring unwelcome volatility all the same. For now, it seems the US market is the main victim – not so good for global growth if it leads to a yet more hawkish Fed. However, the track of European natural gas prices remains the world’s most important energy price.

Europe’s fiscal in-fighting is just getting started
As for the UK, last week offered some respite – though not much. Gilt yields dropped back below 4% (they had touched 5% before the Bank of England (BoE) intervention the previous week) in tandem with the early-week equity rally. Sterling also recovered, reaching the $1.14 level it held before Chancellor Kwasi Kwarteng’s not-so-mini budget two weeks ago. Midweek jitters reversed these trends though, with yields rising and sterling falling into the weekend. Thankfully, these falls were not as severe as the chaos wrought in the last fortnight.

Across the Channel, the European press pulled no punches when reporting on the UK drama. And for a group of countries where balancing the books is sacrosanct, such criticism made sense. Budgetary rules have been at the heart of European Union (EU) policies since the global financial crisis and Eurozone crisis, with some nations – such as Greece and Ireland – forced into stringent bailout programms. But if European leaders are concerned about loosening the public purse-strings at a time of rapid inflation, they can look no further than the continent’s largest economy. Just after the UK’s fiscal event fiasco, Germany announced a €200 billion ‘protective shield’ to help businesses and consumers cope with soaring energy costs this winter. The plan, much like Britain’s, will be funded by new borrowing and includes an emergency cap on gas and electricity prices.

While Britain’s not-so-mini budget clearly put it well in front in terms of energy pricing spending commitments as a share of GDP, Germany’s latest spending programme – fiercely criticised by politicians across the Eurozone – leaves it not that far behind. More importantly, government commitments are high across all of the EU’s major economies (though not as high as the UK and Germany). These include fiscal commitments at or above 3% in France, Italy, and Spain – none of which enjoy Germany’s reputation for balanced budgets.

Within the European Central Bank (ECB), policymakers are already in the process of tightening monetary policy, and energy pressures in the winter will give the motivation to raise interest rates more severely. This is sure to make financing harder for European governments – at the exact moment, some are relaxing their debt constraints. With the EU’s fiscal star pupil Germany now loosening its grip on public finances, the temptation may be there for others to adopt similar tactics. Not only the ECB will be vigilant, but the bond vigilantes are likely to stand ready also.