MUNIX WEEKLY
Cry ‘Havoc’ and let slip the dogs of war!
In last week’s note I wrote:
“Nevertheless, unless there is war in the Ukraine and another surge in energy costs, then inflation should peak in the next few months… can we envisage a peak in the interest rate cycle then? That is certainly what parts of the bond market are signalling”.
This week sadly sees Europe’s most serious conflict since World War II, with Russian efforts to unseat the government of a country on the border with NATO, a country with significant involvement in the production and transportation of a range of important commodities.
Financial markets are usually very capable when pricing in mainstream economic and corporate developments or standard political risks, such as election results in a stable democracy. They find it much more difficult to consider the short- and long-term impacts of major geopolitical stress events. This can be seen with the market reaction to the news that Russia has launched military intervention in the Ukraine. The price of oil has surged past $105 per barrel, its highest since 2014. Reports suggest natural gas prices in the UK jumped by 30% in a day. The obvious concern is that ‘tit for tat’ sanctions between western governments and Russia eventually result in a reduction in essential energy supplies to Europe. Russia is by far the largest natural gas supplier to Europe, providing about 40% of the continent’s gas imports.
One commentator noted that “Surging natural gas prices will keep the Bank of England in a hawkish mood meaning that the pricing of the BoE tightening cycle may hold up better than some”. However the MPC, like other central bank committees, faces a difficult decision. Indeed many central banks and governments in the West might be confronted with a terrible choice between allowing their economies to slide into recession or allowing inflation to spiral.
Certainly inflation may well reach a higher peak and last longer before rolling over. As Paul Donovan from UBS said, “The average oil price over the next three to six months is what will determine wealth transfers from oil buyers to oil sellers, and associated shifts in global spending patterns”. However, the Bank of England also has to take into account both the negative impact on economic activity from a squeeze in real incomes and further damage to business and consumer confidence. The combination of higher energy prices, higher headline inflation, and much weaker stock market wealth means that a conflict in eastern Europe will create pain for many ordinary households in the UK, already struggling to survive amid a squeeze on living standards.
The flight to safety can be seen in several regards: an appreciation of the US dollar as risk capital flows back home, and sharply falling stock markets. However, the degree of re-pricing in government bond markets has been much less. Investors have priced out perhaps one of the expected rate increases in the USA and UK this year, but still expect to see more. For example comments from Fed Governor Christopher Waller laid out the case for a “concerted” effort to rein in inflation, calling for raising interest rates a full percentage point by mid-year. Hence the 2 year and 10-year benchmark bond yields have only declined by 0.1-0.15% in such countries
As I mentioned last week, the gap or spread between the yield on 2-year and 10-year government bonds is traditionally seen as signalling the medium-term outlook for an economy. A steep, upward sloping curve suggests strong growth and inflation pressures, whilst an inverted, downward sloping curve, that is shorter term yields are higher than those on longer dated bonds, suggests economic weakness, even recession ahead. The yield curve has flattened a little more, but at 0.2% in the UK and 0.4% in the USA it does not suggest undue pain ahead. Of course this is very early days in what could turn out to be a very complex and long-lasting situation. Some geopolitical analysts are talking about the end of an era. Central bankers will await more information about how businesses and households react to this week’s extreme news before deciding how monetary policy should respond.
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