Markets Weekly podcast - 12 July 2021

Henk Potts (HP): Hello. It’s Monday, 12th July and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the outlook for inflation. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Mixed economic data, OPEC+ in disarray and the rapid rise in Delta variant cases created a volatile backdrop for financial markets last week while updates from monetary policymakers drove down benchmark yields.

Treasuries were taken on a wild ride.  Ten-year yields fell below 1.25% on Thursday for the first time since February, then recovered and registered their first increase in a week on Friday to finish at 1.36%, still down six basis points over the course of the week.

In terms of equity markets, a rally on Friday helped recover losses. In fact, the S&P 500 finished in positive territory for the week up four-tenths of 1%. All three major US indexes closed at record highs at the end of last week.

In Europe stocks also retraced Thursday’s losses to finish flat on the week. STOXX 600 is just half of 1% off its record high.

Central banks once again took centre stage as Fed minutes reiterated its patient, hawkish tone. The European Central Bank raised their inflation goal. And the People’s Bank of China cut the reserve requirement ratio.

Let’s start with the US central bank where the June minutes indicated the Committee were not comfortable with setting out a specific timeframe for scaling back asset purchases due to the high uncertainty over the economic and inflation outlook.

FOMC members stated that their standard of substantial further progress was generally seen as not being met yet, but conditions for tapering is expected to be achieved earlier than previously anticipated.

So in terms of that tapering timetable, we can expect an increase in noise from the Jackson Hole Policy Symposium at the end of August with a formal announcement coming at the September meeting, then a reduction of the $120 billion monthly purchases beginning at that November meeting starting with $10 billion less of treasuries, $5 billion off mortgage backed securities.

In Europe the European Central Bank has been reviewing its strategy framework for the first time in 20 years. After opining on the matter for the past 18 months policymakers raised their CPI goal to 2% over the course of the medium term compared to the previous target of close to but just below 2%. They said that it would allow for periods of overshoot when recovering from the lower bounce but will adopt a symmetrical framework meaning they will treat overshoots and undershoots with similar vigour.

The move removes the concept of an inflation ceiling and should give officials greater flexibility allowing them to maintain ultra-accommodative policy for longer as the bloc emerges from the pandemic recession.

The framework also reshaped the central bank’s priorities to incorporate climate change and carbon transition into its monetary policy and include the costs related to owner occupied housing when assessing price pressures.

Over the course of the past few weeks we’ve been documenting the slowdown taking place in China. On Friday the central bank reacted to the weakness by cutting the reserve requirement ratio by 50 basis points for all banks effective of 15th July.

The decision releases somewhere around about $154 billion worth of long-term liquidity that should boost bank lending. The decision adds I think to the evidence that Chinese authorities will indeed try to avoid a policy mistake and orchestrate a soft landing for the economy as it exits the recovery phase which if successful of course will be positive for both domestic and global growth prospects.

As I was saying at the introduction, OPEC+ was plunged into crisis last week after the cartel abandoned its meeting without a deal leaving the oil market facing a significant supply and demand imbalance going into the summer months. Despite talks going into extra time, to use a football analogy, Saudi Arabia and the UAE couldn’t resolve a dispute over a reassessment of the Emirates quota baseline and the extension of production cuts until December next year.

In terms of the impact, it means that OPEC+ won’t increase production by the 400,000 barrels per day each month from August as proposed by Russia and Saudi Arabia despite OPEC data pointing to a projected increase in demand of 5 million barrels per day in the second half of this year.

Not only did the group fail to reach agreement they failed to agree the timing of the next meeting. What does this mean for prices?  Well, we saw Brent peaking last week at a six-year high trading above $77 a barrel. It has eased back a little bit since then but higher oil prices of course risk stifling the recovery and fuelling inflation.

In terms of the media outlook, there’s still every chance that a deal could happen intra meeting that would include concessions for the UAE. The tail risk is the OPEC+ group falls apart which could lead to a price war and substantial falls in energy prices though most market participants believe that’s an unlikely scenario. The Bloomberg Intelligence survey found 71% of respondents believe OPEC+ alliance will still be in place through the course of 2025.

So that was the global economy and financial markets last week. With inflation continuing to dominate the mood music in markets and the ever growing debate over temporary versus persistent pressures I’m pleased to be joined by our investment strategist Jai Lakhani to discuss some of the findings from Barclays Investment Bank’s 25th global annual inflation conference.

Jai, great to have you with us today.  As we’ve been discussing inflation has remained a key talking point during the course of this year as the economy recovers. Take us through some of the key inflation drivers and how the recovery has so far panned out differently compared to the past.

Jai Lakhani (JL): Well, good morning, Henk, and thank you for having me. In terms of difference from the past it’s really worth noting how unprecedented it was for economies to go into lockdowns and then reopen activity and what this meant for the recovery inflation. It meant that, yes, last year global economies plunged into a deep recession and inflation fell, but since then we’ve embarked on the strongest economic recovery since any recession over the past 80 years.

So May last year inflation fell one percentage point on average, maybe more so in advanced economies. However, within four months you had inflation starting to rise and by April of this year inflation had already recovered to pre pandemic levels.

This compares with previous crises which have been down to exogenous shock or structural imbalances where average global recessions over the past half century inflation fell six percentage points and typically didn’t stop falling until one to three years. So this can help in terms of understanding why the price pressures are such a talking point and why the rise has led to market volatility.

HP: We know that governments have initiated a huge fiscal stimulus programme in response to the economic and the social impact of the pandemic particularly in the United States. What impact is this having on inflation expectations?

JL: This I think is a key focus really and it’s the question that has the US provided the right amount of stimulus for the recovery or have they gone too far.

So on the one side you have Professor Olivier Blanchard who’s actually been an advocate for fiscal policy for a while but argues that the $1.9 trillion stimulus is too much.  He estimates the size of the stimulus was three times the output gap. And the issue here is wages and these expectations.

The stimulus fuels demand which in turn creates a tight labour market and ingrained wage pressures. This cost is more permanent and firms will find it harder to absorb this and mark up prices with demand at the same time overheating the economy.

And this could then actually mean that while these transitory pressures that we’ve seen fade wage pressures keep inflation. However, the other side, and which is what Barclays Investment Bank argue, is the fact that it is not really supply side issues but constraints in the face of unexpected demand which means supply will react over the next few quarters.

World Bank economist Franziska Ohnsorge attributes nine-tenths of the inflation rise to demand. You also have these question marks over the longer term profile of demand. Yes, $1.9 trillion stimulus is a lot but it will fade very quickly and we have a lot of spare capacity even with the US labour market improving and policy support in terms of fiscal support will likely move towards restraint we have in Biden announcing higher taxes and the UK removing policy support.

And I think finally it’s the key point supporting inflation remaining under control is anchored expectations over the past two decades. We’ve seen this quite clearly with the fact that, yes, inflation has really started to surge yet the expectations over the medium to longer term haven’t really moved and this is key as when we talk about wage pressures it all comes from these expectations.

HP: You mentioned the importance of expectations. What has been driving the anchored expectations we are seeing and can this change?

JL: Well, I think to answer the first part of that question we only need to look at fiscal and monetary policy over the past few decades particularly in developed markets but actually even in emerging markets.  So what we can see is that we’ve also seen this in the crisis recently is that a lot of emerging economies have actually started rate hikes this year to get ahead of any inflation concerns.

When we think about developed economies we’ve seen the Fed who arguably moved too early to hike in 2018 and the ECB after the 2009 recession. And what this has done has made it clear that signs of permanent to longer term inflation aren’t ignored. We’ve also seen fiscal rules being put in place.

In terms of the second part regarding can this change it’s only going to change if we see wage pressures, spare capacity being used up and higher inflation and most importantly central banks remaining on the side lines, ie a repeat of the ‘60s and ‘70s. And I’m talking here of a scenario where you have high wage expectations that also aren’t entrenched.

However, I think it’s quite telling that at its June meeting the Fed pencilled in two rate hikes in 2023 and a more hawkish tilt despite inflationary pressures being described as temporary, ie remaining on the side lines should pressures really become permanent is far from a base case scenario.

HP: OK. So given the potential for a higher inflationary environment where does it make sense for investors to protect their portfolios?

JL: So I think it’s worth pointing out that even for investors sceptical of sustained inflationary pressures there are still likely to be short to medium term pressures so portfolios as you rightly say need to be sheltered from this.

From an equity standpoint it continues to make sense to trim down cyclicality and focus on quality companies with strong pricing power and strong cashflow. This should provide returns in both scenarios and it’s exactly what we brought to centre stage a couple of weeks ago at the midyear outlook.

From a fixed income lens there are three considerations. The five to six-year segment of the rate curve does appear to hold value whilst mitigating the duration risk and short duration high yield has performed well in inflationary environments but of course here selection is key.

I guess for the inflation bulls with anchored expectations currently leveraging linkers could prove a possible strategy if proven correct and at the very least linkers have historically provided a relatively nice return profile.

However, where we can really see some clear winners are through the addition to portfolios of private markets, hedge funds and real assets. We’ve shown the performance of private markets over the longer term have outperformed our traditional asset classes. We’ve shown with hedge funds they provide the asymmetric return profile and diversification benefits as well as performing strongly in both low interest rate and high interest rate environments.

And the final point I’d mention is real assets and with this our preference for infrastructure. What’s important here is you get two benefits. Firstly, the inflation hedge as rental income tends to be linked to inflation. And secondly, as we’ve seen in past podcasts, the fundamental advantage given it will shape the next decade and could drive longer term returns.

HP: Well, thank you, Jai, for those insights. Investors will certainly be focusing on inflation once again this week as reports for June are released.

In the US we forecast headline and core CPI to have increased by half of 1% month on month. However, the pace of monthly core CPI inflation is likely to slow in coming months in comparison to April and May as increases in categories such as used cars, airline fares and hotels should decelerate from the highs of the past few months. If so, this would suggest the inflationary pressures have peaked and could subside further as demand moderates and bottlenecks ease.

Nevertheless, we expect price pressures in the economy to remain elevated throughout the course of the summer months pushing annual headline and core CPI to multi decade highs.

In the UK a similar picture playing out. We expect June CPI to print at 2.2% year on year, core CPI to come in at 1.9%. We do expect inflation to peak at 2.8% later this year but do not expect this to concern the Bank of England as inflation’s set to fall back towards the target level in 2022.

With that, I’d like to thank you once again for joining us. We will of course be back next week with our latest instalment but for now may I wish you every success in the trading week ahead.