MUNIX WEEKLY
Every little bit hurts
I fell off my bicycle a few days ago. The good news was no broken bones. The bad news was not only some spectacular bruising but, even as my body recovers, I realise that there are a few more areas of pain.
So it is with the economic data this week. The bad news was the surge in UK headline inflation. The even worse news is more pain ahead. And the good news is signs that this inflation path should eventually roll over, unless external circumstances create a massive new problem.
UK consumer price inflation climbed to a 30-year high in December, with the annual rate reaching 5.4 per cent, up from 5.1 per cent in November and above market expectations. Unlike some surges, there was no single specific reason for this further deterioration. A complicated mix of food and energy, household goods and leisure costs all added up. This is not the peak, widely expected to be in April when inflation could reach about 7%. That is when the household energy cap is due to rise, with gas futures prices suggesting a 50% increase. Hence electricity costs will add over 2 percentage points to the headline inflation rate for most of 2022.
There was relatively good news from the latest labour market report. Companies are definitely hiring. The ending of the furlough scheme has been a smooth success, with no discernible increase in redundancies. The number of employees on payrolls stands 409,000 above the February 2020 level. Job vacancies reached 1.24 million, 462,000 higher than the three months before the pandemic began. The unemployment rate fell to 4.1%, within a whisker of its pre-Covid level. However, wages, excluding bonuses, only grew at an annual rate of 3.8% between September and November. Naturally, the Bank’s Governor Andrew Bailey has warned that he will be watching for signs that cost pressures are feeding into wage demands. So far, though, there is no major cause for concern about a severe wage-price spiral.
What sort of medicine might the doctor prescribe? The debate is growing about whether the Bank of England might move again on rates as soon as its next meeting on 3rd February. Consensus expectations are that headline inflation is likely to still be around 4% at year-end, and the Bank will want to be sure that inflation expectations do not deteriorate. The market is debating whether three or four moves will be sufficient this year, in addition to any ‘quantitative tightening’ that the Bank is likely to undertake. Sterling’s momentum versus the Dollar and Euro may be a good ready reckoner. The unknown factor will be how households and businesses respond to an approaching shock – real disposable incomes are set to deteriorate sharply by about 4% from April due to rising NI and utility bills, which will erode consumer demand.
UK gilt investors have responded to this data and debate, pricing in base rate rising about 1% this year, hence ten-year yields fluctuating around 1.25%, closer to the technical peaks of around 1.3% seen in the early 2019. Of course the global backdrop helps explain this momentum. US Treasury yields hit a two-year high after some aggressive comments from officials highlighting the central bank’s readiness to move. The terminal rate for the Fed Funds cycle is now priced at 1.80% versus 1.60% last week. One aspect of this debate has been US investors starting to speculate about interest rate moves by the Fed might be 0.5% rather than 0.25%.
This partly depend on two unknown factors. The first will be the effect of Fed QT, that is shrinking the central bank’s bond portfolio, because of its uncertain effects on liquidity and valuations across a range of risk assets. The second will be geopolitical events, especially the stand-off between Russia and Ukraine, and what this might mean for US/European sanctions and interruptions to gas supplies. Oil prices are already at a seven year high on IEA forecasts that global demand in 2022 will return to 2019 levels.
The markets have been bruised in the last few days. They can recover as long as there are no major shocks.
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