MUNIX WEEKLY Commentary
10 Days that shook the world!
“Ten Days That Shook the World” is a well-known book by American journalist and socialist John Reed, who wrote a first-hand account of the Russian October Revolution of 1917. The political and economic ramifications of that political shock lasted decades. Investors are casting their net widely as they search for historical comparisons to current events in Ukraine. Some refer to the late 1930s drift to world war, others to 1950 Korea or the 1973 Yom Kippur war. Better comparisons might be made with either the Cuban missile crisis in 1962 or Iraq’s invasion of Kuwait in 1991. Both were unpleasant surprises which kept financial markets under pressure for 5 weeks and 7 months respectively before a political & military solution was eventually achieved.
Financial markets are trying to price in a complex world of sanctions, military and diplomatic news, corporate decisions to cancel long-standing supply chains and business models, and consumer responses. It is no surprise, therefore, that asset prices have been rather volatile. US benchmark bond yields were over 2% before the invasion, slumped to 1.65% as investors rushed to find safe havens, and have snapped back towards 2% once again. Last week, German benchmark bunds had their best performance in over a decade.
The problem facing bond traders is that different drivers point in very different directions. A report from one group of economists caught my eye. It publicised the results of its recession prediction model, based on the shape of the US yield curve, and concluded that there was a 40% probability of recession ahead. Other economists are more sanguine, merely warning of a stagflationary shock. Certainly in the short-term inflation will be pushed higher by all the disruption caused by the war. Oil prices currently between $120-130 per barrel suggest that headline inflation in the UK and USA could easily reach 8 to 9% a year before peaking and slowly decelerating.
Time and again central bankers have made the statement that they should ignore soaring energy costs but should continue fighting home-grown inflation. However, the problem facing policymakers is that there are abundant signs of such home-grown inflation. While headline US consumer inflation in the year to March was as high as 7.9%, the core or underlying rate excluding food and energy was still as high as 6.4%. Similar trends were seen in the European data released recently.
Most households face a stagflationary shock, but both investors and tax payers must also consider a new issue – the effect of the crisis in Ukraine on fiscal policy. There are strong pressures for a sizeable increase in defence spending in all European countries. Even a neutral country such as Sweden has announced its defence budget will rise from 1.2% to 2% of GDP. Low-income households will need considerable support as petrol prices squeeze budgets, hence the pressure on the Chancellor to delay the rise in National Insurance contributions. Can he compensate via higher receipts from petrol and diesel taxes, or must renewed borrowing take the strain? Governments also know that they will need to spend much more, and encourage business to invest more, in energy security – renewable energy, infrastructure, LNG terminals, nuclear plants etc. The danger of relying on Russia for energy security is simply too great.
Such stagflation concerns show up dramatically in bond markets. All the increases in real bond yields driven by the hawkish tone of Fed commentary have been undone by the invasion. Ten-year inflation-linked yields are back at historically extreme lows that suggest near-certainty about weak growth ahead. Conversely inflation expectations embedded in bond markets have surged in recent days.
How are central bankers responding? The ECB meeting on Thursday signalled a more aggressive tone. It will alter its bond buying programme more quickly opening the way for the first interest rate increase before year end. The subsequent sell-off in German bonds has taken them above 0.25%, their highest level since early 2019. The MPC and Federal Reserve are still expected to raise rates later in March. Indeed, money markets are pricing a total of 1.5% of interest rate hikes from the Bank before the end of the year.
Even if peace descends quickly on Ukraine, the ramifications of this war will percolate through the financial system for some time to come. In the short-term, bond markets are focusing more on the inflation than the growth implications – but market sentiment is volatile.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 1.72 1.94 2.00
UK 1.37 1.33 1.54
Germany -0.39 0.0 0.28
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making