Markets Weekly podcast - 1 November 2021

Julien Lafargue (JL): Welcome to a new edition of Barclays Market Weekly podcast. My name is Julien Lafargue and I’m the Chief Market Strategist for Barclays Private Bank, and I will be your host today.

As usual, we will go through the events that defined last week in the markets, before moving on to our guest segment. And this week I’m delighted to welcome Fabrice Montagné, Chief UK Economist at Barclays Investment Bank, to discuss everything from the UK economy, the recent Budget, and the path forward for the Bank of England.

But before that, let’s take a closer look at last week’s events. First and foremost, investors had to digest a huge number of companies’ quarterly reports. In the US, the focus was on the broader technology space as the FAANG – which could soon become the MANGA as Facebook announced its intention to become Meta – reported earnings.

Although, with Tesla surpassing the trillion dollar valuation, and Microsoft becoming the most valuable US company, we may in fact refer to the group as the MAMATA from now on.

But acronyms aside, the infamous group of companies have delivered rather mixed earnings, with some spectacular results from Microsoft, some hit-and-miss from Apple and Alphabet, and some outright disappointment from the likes of Amazon and Facebook. With half of the S&P 500 companies now having reported, and with more than 80% of them having surprised positively by an average of 10%, the year-over-year growth is now expected to reach 39% this quarter.

This would be another very strong quarter, but as we expected, surprises aren’t as meaningful as they were in the first and second quarter of the year. So overall, this leaves us with a stable to slightly higher earnings estimate for the full year, 2021, but also for 2022.

This is positive as we really need earnings to support further upmarket upside. This will be another busy week but we don’t really expect the narrative to change that much. And outside of the numbers, the main takeaway from the earnings season will be that while, first according to management teams, input costs are likely to continue to rise going into next year, and second that supply-chain disruptions still exist but aren’t getting worse, which is clearly a positive.

The second important event of the week was the ECB meeting. As the central bank did not make any announcement, as widely expected, president Christine Lagarde took this opportunity to push back against market expectation by not pricing in the first rate hike by the end of next year.

By reiterating the governing council’s view that inflation is indeed transitory, albeit lasting longer than initially expected, and by reinforcing the message that the ECB’s condition for lift off will not be satisfied by the time the market is pricing in this first hike nor actually any time soon thereafter according to ECB, President Lagarde came across as quite dovish.

Yet, the market largely ignored her comments and rate moved higher in the region. And this is probably because, although the ECB remained largely silent about this issue, there are growing questions about the central bank quantitative-easing programmes.

It now appears that post the PEPP asset purchases have been scaled back from making a significant volume of additional purchases to simply providing an insurance mechanism in case of market stress. And like many other central banks in the world, the ECB is really trying to walk this fine line between still relatively fragile recovery and mounting inflationary pressure.

Talking about inflation, the sudden last key information that we got last week was the US PCE number for September. While this is a bit outdated by now, it remains the Fed’s preferred measure of inflation and is, therefore, very important to watch.

For the last month of the third quarter, inflation was up 3.6% year over year, just below consensus expectation of 3.7%, yet this remained very elevated by recent historical standards. In addition, and maybe more importantly, the Q3 Employment Cost Index, or ECI, jumped more than anticipated at +1.3% quarter over quarter.

The consensus was looking for only +0.9%. And within that, wages and salaries for civilian workers rose 1.5% in the quarter, the largest advance in the series’ history, dating back to 2001.

And this is critical, because, unlike the average hourly earnings figure in the monthly job report, the ECI isn’t impacted by employment shifts across industries and occupations, something that has been particularly severe amid the pandemic.

So although Q3 may have been particularly impacted, this number seems to confirm that wage inflation is real, something that we’ve repeatedly highlighted as a key sign that the transitory narrative could become challenged. And clearly, inflation and wages will remain a hot topic for investors as we enter 2022, and portfolio needs to be positioned accordingly.

Of course, there was another key piece of information last week and that was the UK Budget ahead of this week’s Bank of England meeting. The reason I haven’t detailed any of the announcements made by Rishi Sunak is because I’m very pleased to be joined by Fabrice Montagné, Chief UK Economist at Barclays Investment Bank, who will be able to tell us all about this and even more.

Fabrice, thank you very much for joining us, and let me start with a very simple question. What’s your current assessment of the UK economy in terms of both growth, but also very importantly in terms of inflation?

Fabrice Montagné (FM): Yes, hi, Julien. Thank you very much for the invite. Listen, in terms of where we currently are for the UK economy. So in terms of growth as you might know, you know, we recovered to 1%, 2% of pre-pandemic levels which is, you know, which is fine, which is what we see in other economies as well. Some economies are a bit earlier, others are a bit later, but no big difference here in terms of, you know, whether the UK stands out in any way.

I think, what’s a bit more interesting is the amount of, whether we have any momentum going into, you know, the end of the year now or into next year, and it seems that, you know, we have a lot of doubts on whether the kind of high growth we’ve seen in the second half of this year could be sustained.

We’ve seen sectors switching off, one by one, once they reach, you know, pre-pandemic levels. Supply-chain disruptions are quite clearly crippling some areas of the economy while at the same time, you know, new COVID cases are on the rise again. So while the latest survey, for instance, if you take October PMIs, for instance, showed quite some resilience in the business sector, especially in services.

We also had consumer confidence dropping like a stone in October highlighting that, you know, this second phase of the recovery, if I may, is going to be much more complex, and a bit darker and confused than the first half of the recovery was.

Now as you pointed out, you know, the market didn’t really react to growth surprises so much than it did to inflation. I mean clearly inflation is the bigger news here. Yes, inflation has been on the rise, it has been a broad-based recovery, a lot of items contributing to high inflation.

But it is important to point out that only a limited number of items contribute to excess inflation, at least to inflation above 3%, above 4%. I mean here we’re actually only talking about energy, we’re talking about second-hand cars, we’re talking about a couple of manufactured goods here and there, but fundamentally we don’t have that many goods that are overheating in terms of price inflation, right?

Fundamentally, businesses are struggling to pass through input price increases to final consumer prices. Think about supermarkets or retailers, they are desperate to restore the margins, but because of the lack of demand that they’re facing, there is a high cost to be the first movers so nobody moves.

They might use this seasonal, you know, year-end shopping frenzy to actually pass through those prices, but then the risk is that, you know, in the early stages of next year we see quite a sharp slowdown in sales because prices are just not in line with where wages are, right?

In terms of wages we, to be clear we fail to see a broad-based increase in wages so, yes, some sectors facing high demand are currently also increasing wages because they can afford it. Think about typically, you know, a lorry driver and so on. But this is not the case everywhere and, you know, I’ll come to it in a second when talking about the Budget.

The Budget still under constraint means that there’s not so much upside on public sector wages, for instance, and it will be similar in many, many other areas of the economies. Just be remembered that, you know, hours, jobs and hours per job are still below the levels we had pre-pandemic. So by no way, you know, is the labour market on aggregate overheating. It’s not, not yet.

So that leads us in monetary policy. And why do we have then, such an urgency, you know, in hiking rates, you know, and at least in the words of the hawks of the MPC, it seems that this week’s meeting is live so, you know, the market has clearly listened to some of the statements and has priced a decent chance of a hike already happening this week.

Now the interesting thing about this week is that we don’t have likely enough data to justify a shift from the stance that was put out in August and September. I mean we hardly have any post-furlough labour market data, and as I pointed out previously, the rest of the data on activity and inflation for that matter is, I mean, can be read in two different ways.

So we kind of think that if the bank wants to move early, and really much earlier, is either because it thinks it has credibility issues and it’s worried about anchoring inflation expectations, or it has something to do with Brexit.

Now here I didn’t mention Brexit yet, but here it comes. The interesting thing about this is we’ve seen quite significant changes in immigration patterns with a lot less economic immigration coming from, well, virtually everywhere but specifically from the continent. That means that, for instance, one number I want to, I want you to know is that labour force, right, its working age population is 250,000 people less today than it should have been if the pre-pandemic and pre-Brexit trends were continued.

Now 250,000 people, that’s around half a point of GDP, right?  So it’s not nothing. It could explain why output gap is already positive and not negative. And that’s an important differentiating factor from other regions that didn’t experience the same changes in demographics. And that, in my view, is probably one of the most relevant reasons for the Bank of England to actually increase early.

But still we, you know, as Julien mentioned, we’re a bit, you know, hesitant to see a move already this week because there’s absolutely no data and we think that there will be enough members on the MPC pushing back against that. We see the first hike in December, something like 15 basis points, and we see then further hikes, you know, in the course of early next year to bring rates maybe to 75 basis points, but no more.

Yeah, that’s, listen, we’ll obviously know much more this week, but for now that’s the stage of our expectations.

JL: So if I can jump in, let me sort of recap of that. So the UK economy is doing OK but it’s going to be challenged for, going forward. It’s not all great. And when it comes to the BoE, they are probably going to take some more time before first rate hike towards December and then potentially a bit more last week.

FM: Correct.

JL: Now let’s move on to, quickly, to the UK Budget because I want to get your take on what’s been announced. Obviously a lot of headline-grabbing announcements, but what really is the impact on the UK economy from your perspective?

FM: Yes, so listen, the Budget, so I saw all the headlines, I saw all the leaks in the weeks before going into the Budget, but if you look at the measures that were actually announced, apart from funding NHS and healthcare with an increase in National Insurance contributions, there’s actually not much that is bigger than a billion in kind of new measures, right?

So to be clear, this Budget was maybe very headline prone, but from an economic point of view there’s hardly any change in the kind of stance we had previously, and the direction of travel here is still to reduce the Budget year after year, to reduce the structural year after year, so the next two or three years will be dominated by austerity, you know, in the shape of Budget consolidation.

Now the twist, and what made a lot of headlines, you know, around the Budget announcement last week is that the government seems to be embracing a bigger state role, right, and funded by higher taxes in the recovery.

The share of tax per GDP is the highest since the ‘50s, the spending per GDP is highest since the ‘70s, so definitely here a change of approach on how to run a government. And a lot of, you know, reverting the efforts of previous Conservative governments over the past decade. So that’s quite interesting.

To be clear, there’s nothing wrong about big state, you know, I mean there’s certainly a role especially in the case of the UK where the state was fairly lean. There’s some, you know, place for a bigger role for the state in terms of spending. Also, think about, you know, ramification of Brexit means that the European Investment Bank is not investing in the UK any more, or that the UK is not being funded by European Commission structural funds. So the government definitely needs to step in those areas, right? 

So clearly a bigger state makes sense and, you know, not even mentioning climate change, where all governments around the world will need to step in and take on a bigger role. But clearly here what I’m getting at is that the way it has been presented so far is that this bigger state is funded by a very tax-rich recovery. So if you’re only a notch less optimistic than the OBR with respect to the medium-term recovery in the UK, you will run into some problems here in terms of tax receipts and income, right? 

And you might have to choose between either increasing taxes more because, you know, there’s a lot of tax increases in this budget, but you might have to do that more if you want to meet your spending commitment or you have to scale down, you know, some of the commitments you make.

So there is here something to be said about the next two or three years, you know, whether or not economic forecasts do match what the OBR’s sort of fiscal watchdog has pronounced and that in our view is a reason to be a bit sceptical on the amount of either spending or Budget consolidation that we’ll see.

Another interesting theme, I think, when it comes to the Budget, is that both fiscal policy and monetary policy are turning restrictive at the same time, and over the next year or so we’ll see both fiscal and monetary tightening with an impact, you know, that gathers pace and magnitude in the course of ’23. So ’23 could be a year where we see a lot of headlines coming both from the fiscal and the monetary.

Think about, you know, the monetary tightening as priced in by the market currently, which is something like 100 basis points over two years, might actually weigh on growth and inflation by something around half a point of GDP and 50 basis points on inflation, so half a percentage point on both. That’s not nothing, right?

And the same holds for the fiscal, where we’re facing 1%, 1.5% of Budget consolidation at that horizon. So we could easily be in a situation where public policy shave off 1% of growth in 2023, at the moment where, as I highlighted previously, energy prices might be coming down, inflation might actually crash below 2%. So the discussion might be radically different, you know, when it comes to 2023 than where we are currently in today.

So that’s also an interesting switch, you know, that we’ll be following obviously over the year and to see how that plays out.

JL: Well, thank you very much, Fabrice. Great to have all this insight when so much is happening in the UK, not just this week but over the next couple of years, so we’ll definitely have you back to give us more of that very precious insight, really appreciate it.

Before we conclude, I just wanted to take a quick look at the week ahead. With the bulk of the earnings season now behind us, the focus will likely return to macroeconomic considerations. In fact, this started earlier today, with lower-than-expected October Caixin PMI in China, where the non-manufacturing index dipped to 52.4 from 53.2 in September, and the manufacturing component sank to 49.2 when the consensus was looking for a slight increase to 49.7.

Contrasting to that, the official NBS PMI was actually slightly better than expected and above 50, signalling that really the Chinese economy is very much stagnating at this point.

Beyond that, on Wednesday we’re going to have the Fed, which is expected to formalise its tapering process, with the only question really remaining at this point, is at which pace will they do this tapering. Is it 10, 15, 20 billion per month? 

Followed by that, we’re going to have the OPEC on Thursday. Again, quite unclear if the recent surge in oil price will be enough for the group to reach any kind of consensus around increased production.

And finally, on Friday we’ll get the October nonfarm payroll in the US. The consensus is anticipating 450,000 new jobs, a shock rebound from the 190,000 recorded in September. However, as I mentioned previously, with tapering probably already announced by then, it will go back in terms of impact to the pace at which the Fed will slow its purchases more than anything else.

So the next few days will certainly be very busy, and with that I’m looking forward to be back here next week and I wish you a great success for the trading week ahead.