“For the loser now will be later to win… for the times they are a’changin“
Bob Dylan, The Times They A-Changin’
Last week, we focussed on inflation and the significant implications for global financial markets from the recent undershoot in the US inflation print. Yesterday, in keeping with our sentiment, one of the arch hawks on the FOMC, St. Louis Fed President, said that he expects “rapid disinflation” once the process takes hold (the stairs may well be steeper on the way down!). The big question for markets is how the inflation path evolves in the near term and how growth and monetary policy respond.
We do not subscribe to the permanent or structural shift thesis for higher inflation - indeed we think that the prospect of disinflation in 2023 and deflation in 2024 is perhaps a higher probability event. While there is much speculation in the market about the persistence of inflation, all economist and Central Bank forecasts that I have seen show inflation coming back to target over the forecast horizon (or thereabouts). While the pace at which this occurs has implications for second round effects and inflation expectations - which have remained remarkably stable globally throughout the recent turbulence - there is no doubt that as the COVID impact fades in the global economy, supply-side constraints will gradually resolve and excess demand as a function of COVID stimulus (and or excess pandemic savings / revenge travel) wane, supply and demand will find a better balance and inflation should normalise.
It is not clear that Central Banks should intentionally force demand destruction to counter temporary, supply driven inflation. Indeed, as demand peaks we would suggest that the urgency of Central Banks to act is likely to change significantly as the second derivative of inflation changes (as we have likely now already seen in the US) and economies slow - some into contraction.
Furthermore, as inflation slows, risk premium must be reduced in term interest rates (especially with current yield curves beyond most estimates of r*, or the equilibrium interest rate) especially if inflation expectations continue to be well behaved - driving real yields higher. Lower rates and lower risk premium should see higher risk asset valuations and from a currency perspective foster a move away from the concurrent tails of the ‘dollar smile’ and into the trough - undermining the USD in FX markets.
This week, the focus has shifted back towards the UK - Outside of the short-lived concerns of an escalation of the Russia / Ukraine conflict via Poland - with plenty of Macro data and the all-important Autumn Statement.
With the labour market continuing to hold up well, there is not clear evidence of an imminent collapse in demand (the unemployment rate edged up to 3.6% from 3.5% - admittedly this data is from September and a lot has changed since then, but we are still hovering around record lows / record tightness in the labour market, with average hourly earnings running at a robust 6.0% growth rate). However, there was also a further upside surprise to the inflation rate taking the October’s reading to an annual rate of 11.1% - beyond the level that the Bank of England expected to be the Q4 peak as recently as last week.
At some point we expect house prices to feed into the negative demand dynamic as property price declines weigh on sentiment (the opposite to the reinforcing impacts on confidence house price ‘wealth’ brings in an upswing) - especially as it is likely that much of the past BoE policy tightening is yet to be felt in the property sector (a major protagonist in the ‘long and variable lags’ premise of monetary tightening). Retail sales held in well on a headline basis this week, but the ex-auto fuel component hints at complicated spending choices going forward and lower discretionary spending.
In reality though, much of the immediate UK focus was on the Chancellor of the Exchequer, , and the Autumn Statement. Going into the budget the central message from the Sunak/Hunt narrative (and the gradually yet purposefully leaked fiscal tightening components), was the message of fiscal and monetary cohesion - or fiscal tightening working in conjunction, not divergence with the monetary trajectory - the opposite approach from the Kwarteng ‘mini-budget’ sent gilts and GBP into a tailspin. Hunt spoke of “compassionate conservatism” and an increased tax burden that falls largely on the “broadest shoulders”, but over the full five-year term, there is a clear fiscal contraction.
That said, there was also a significant political angle to the budget in that much of the tightening in the projections was back loaded - i.e., after the next general election - with a modest loosening at the front end (the deficit goes up in the current year and doesn’t fall significantly until 2024-25). Ultimately, this is aimed at fostering a shallower than expected growth slowdown in the near term, both through tax and spend mismatches and a likely lower, flatter path of Bank of England rate rises and thus the yield curve. Indeed, the accompanying OBR growth projections saw 2022 revised up to 4.2% from 3.8% and a contraction of 1.4% in 2023 (from a previous expansion of 1.8% - but more in line with the BoE’s forecasts.)
All in all, the reaction of the markets was modest. Not quite a yawn - but not far off. Just as the Chancellor would have hoped for given the market reaction to the now infamous ‘mini-budget’ of his predecessor. When the dust settles on the fiscal prudence argument, however, we are left with one question. Where is the growth coming from, how does the UK solve the productivity puzzle? A higher UK growth trajectory is not only needed to recover from the faltering output gap at the hands of the pandemic and its fall out but also to make the Chancellors figures work - whether he is at the helm in 2024-25 or not. The Chancellor of the Exchequer spoke of aspirations for the UK to become a global science superpower, a new Silicon Valley (defined by technology, AI and robotics) and the use of Brexit regulatory freedoms to promote this vision. Sadly, like the projections for declining debt to GDP (and even the Nuclear and energy self-sufficiency plans), we will have to wait and see.
For GBP, and even perhaps for Gilts it is likely however that the situation is dominated by global factors. The Autumn Statement has bought stability (as was likely its primary objective - closer to the election the Conservative Party’s objectives and thus their proposed policy path may be very different - especially if inflation and gilt yields are markedly lower). However, the likely path of BoE tightening is little changed following the Budget - the BoE are in our view close to the end of their tightening (consistent with a Gilt curve relatively flat around the current Bank rate). Indeed, the US inflation backdrop and the implications for the USD and for term rates in the US are, for us, likely to remain dominant.
Market commentators continue to have negative outlooks for GBP in FX markets, but for us, the inflation dynamic - particularly in the US - is dominant. If we incorporate the negative sentiment and positioning in GBP, then the Times may well be Changin’ for GBP too - as a function of the inflation, risk asset and USD backdrop!
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Bloomberg Article: Bullard Sets Tone for Fed Officials Signaling Hikes Will Roll On - https://www.bloomberg.com/news/articles/2022-11-17/fed-s-bullard-says-more-hikes-needed-to-get-to-restrictive-level
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