Weekly update - No time for complacency
This week’s update is written by Pierre Paul, in our cash management team.
Our last note entitled “The Only Way Is Up” highlighted the fact that the central banks in the US, the UK and Switzerland had raised interest rates and were likely to continue to raise interest rates. Our note also highlighted how this central bank activity had wreaked havoc on the equity and bond markets.
Since then, the US and UK central banks have continued to raise rates and, in fact, have now been joined by the European Central Bank. Recent rate moves by the US, UK and EU central banks are shown in the table below:-
Central Bank |
March Note |
June Note |
August Note |
US Federal Reserve Bank |
0.25% to 0.50% |
1.50% to 1.75% |
2.25% to 2.50% |
Bank of England |
0.75% |
1.25% |
1.75% |
European Central Bank |
-0.50% |
-0.50% |
0.00% |
Readers of this note would be forgiven for thinking that we are about to launch into a defensive explanation of further equity market disappointment but you will be delighted to hear that contrary to expectations, the equity and bond markets have performed reasonably well over the last few weeks. This is not a time for complacency though, as there are plenty of threats at large that could re-ignite the recent market volatility. However, a brief explanation of the gains in the equity and bond markets is necessary.
In no particular order…
First, central bank communication – Generally the central banks have communicated their rate rising intentions very well, giving the financial markets time to adjust their expectations and thus avoid the so called “taper tantrum” when in 2013, Federal Reserve Chair Ben Bernanke announced that the US Federal Reserve Bank would, at some future date, reduce the volume of its bond purchases. The “tantrum” led to a surge in bond yields and corresponding collapse in bond prices. Whilst there has been a similar surge in the wake of the recent round of interest rate rises it was reasonably predictable and since then bond yields have begun to ease off bringing some respite to the bond markets.
This leads on to the second explanation which is inflation.
Price inflation has, as a result of soaring energy (oil and gas) prices and supply chain constraints, reached heights not seen since the 1970s. This inflationary shock took central bankers by surprise, despite that fact that inflation had started to creep up last summer. However, it was dismissed as a temporary phenomenon caused by post-Covid gains in economic activity which would quickly be assimilated by efficient markets re-establishing pre-Covid normality. The central banks couldn’t have been more wrong as demand continued to grow without a commensurate improvement in supply. Energy prices had already been rising when, in February, the threat of Russian aggression manifested itself in a full-scale attack on Ukraine and consequent oil price surge. Whilst the invasion should never have happened, the reaction, viewed from the safety away from the horrors of Ukraine, was predictable and importantly logical.
Accordingly, the fact that central banks had said that they would deal aggressively with inflationary pressure by raising rates has been accepted remarkably calmly by the financial markets.
Since then, inflation has appeared to have possibly peaked. A key piece of data was last week’s US CPI data for July; this came in at 8.5%, lower than the 9.1% registered in June and which, according to Bloomberg, was “lower than virtually any analysts had forecast” and having interrupted a string of strong numbers is “reasonable to think that the peak for headline inflation — including food and fuel and everything else — is behind us”1.
So, are we being complacent?
Well, at our latest regular CIO Macro Update we discussed the Bank of England’s latest Monetary Policy Committee minutes, particularly the comment that “the United Kingdom is now projected to enter recession from the fourth quarter of this year”, followed by the statement that “Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.”2
The talk of recession is significant and we queried why, if this is the Bank of England’s forecast, has the reaction of the financial markets been so sanguine?
One comment was that maybe the talk of recession is linked to the terrible times etched into our memories of the 1970s recession caused by rampant oil prices rises which eventually led to strikes, short working weeks and electricity blackouts. The commentator went on to say that we should remember that the UK economy is very different today than it was in the 1970s. These days there is more emphasis on financial services than heavy industries such as mining and steel working. The same could be said of the US with the dominance of Silicon Valley over the old “Rust-Belt” industries of the US Midwest.
The argument therefore is that because our contemporary economies are so different from the 1970s that maybe the next oil-price-induced recession, if there is one, will not be as severe.
History, as we have seen in the Ukraine, does repeat itself so we are definitely not being complacent and constantly evaluate our investment decisions, regardless of which of our services you are invested in.
We hope you have a good week.
Sources:
- 1 Bloomberg
- 2 Bank of England