MUNIX COMMENTARY – 8th October
The Boxer staggers onto the ropes
Financial markets are starting to feel punch drunk. After a quiet summer, a series of body blows have landed in the autumn. Whilst a rise in UK interest rates this autumn or next spring should not be a knock-out blow, such a punch is seen as increasingly likely. Hence UK 10-year borrowing costs have touched their highest level in almost two and a half years at about 1.15%, with the US yield at 1.6% is the highest since May.
Inflationary worries are rising across most parts of the world. The causes are global as well – a complicated mismatch of demand and supply, partly related to climate issues and partly man-made. The most obvious is the surge in energy prices. A lack of wind and water in the right places have affected renewable capacity, leading to a jump in demand for natural gas, which in turn rippled through to oil and coal. The news this week that OPEC would not raise production enabled the oil price to reach a 7-month high above $80. In the US, pump prices for gasoline are their highest for seven years. The price of thermal coal has also soared partly related to China’s efforts to curb pollution ahead of COP26 and the winter Olympics and partly the result of a ban on imports from Australia due to due diplomatic disagreements. As many more countries search for LPG, and Russia prefers not to expand its gas exports, so here in the UK natural gas futures are 6 times the average price seen from 2010 to 2020. Across Europe, governments are scrambling to find ways to alleviate the burden that soaring energy bills will impose on households this winter.
It would be wrong to focus on energy – silicon chips are an example of another industry where there is a serious shortage of supply vs demand. Knock-on effects are evident in the car industry; US auto sales have fallen back to 12 million units, versus 17-18 million in a normal pre-pandemic month. New car registrations in the UK were the lowest for September since 1998. Transport costs are also rising, both lorry and container ship, as is the length of time it takes to deliver goods from factory to shop to consumer. The net result is that companies are warning about future price increases. More British manufacturers plan to raise their prices than at any time in the past 3 decades, whilst the share of service sector firms planning price increases is the highest since 2008.
Central bankers assume that many of these price increases will eventually fall back, but they are worried about second round effects being seen in the labour market. In the UK, depending on which measure one chooses, then wages are already growing at an annual rate of 4-5%. KPMG and REC noted that starter salaries and temporary staff wages are rising at their highest rate in 24 years. There are also reports that professional salaries are rising due to a lack of suitable candidates. The next few labour market statistics will be analysed carefully at the Bank, especially in the light of comments from the Prime Minister about wanting a high-wage, high-skill economy.
In the USA, the most recent employment data rather complicated the Fed’s decision about what to do next. The simple answer will be to wait for more data! Payrolls have only risen in August and September at about half the rate expected at this point in the recovery. Although demand for workers remains high according to business surveys, the Delta variant is still causing serious disruption while there is some evidence that people are leaving the workforce wanting a better work-life balance. Nevertheless, US wages are almost 5% from a year earlier, albeit there are measurement problems as different sectors are in lockdown to a greater or lesser degree.
The net result is that on some estimates in the inflation swaps markets there is a risk that UK inflation as measured by the RPI will rise to 7% in 2022, the highest level since the 1990s, and could average around 4% over the course of 10 years. The Bank of England is recognising this; Huw Pill, the new Chief Economist at the Bank of England, has warned that the current strength of inflation looks set to prove more long lasting than originally anticipated.
The boxer faces another punch or two – the market-based probability of two UK rate hikes by the March 2022 meeting is nearing 90%. Benchmark bond yields are responding, and many bond investors will desperately hope to see a rapid collapse in energy prices before the bell rings the end of the round.
Andrew Milligan is an independent economist and investment consultant. This note should be considered 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