Markets Weekly podcast – 31 October 2022

Henk Potts (HP): Hello. It’s Monday, 31st October 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 with 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 geopolitical outlook. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.  

There was a vast array of data and earnings, along with political and central bank developments, for investors to digest during the course of last week. The latest economic data releases continue to point to a deterioration in future levels of activity, as evidenced by the slump in European and Chinese PMIs and the contraction in services manufacturing and housing from the United States. Although markets currently view the softening data as positive, as it takes some of the pressure off the rate-hiking trajectory. 

In terms of earnings, the US third-quarter reporting season has now passed the halfway point, and in aggregate continues to be positive. Seventy three percent of companies that have reported have beaten consensus expectations. Analysts see third-quarter S&P 500 earnings growth of 4.1%.  

However, lacklustre guidance from the US tech companies, including the likes of Alphabet, Microsoft, Meta, and Amazon led to a mini mega-tech meltdown midweek, although tech stocks rebounded on Friday as investors regained their composure. 

In terms of politics, in the UK, markets appear relaxed about the delaying of the autumn statement until 17th November, after the British Prime Minister promised a new era of fiscal responsibility. 

In China, investors offered a cautious welcome to President Xi’s unprecedented third term and his new politburo standing committee. The concentration of power will see the country maintain its commitment to zero COVID, transition from high-speed growth to high-quality development will focus on domestically driven, scientific, and technological breakthroughs, and look to standardise income distribution and wealth accumulation mechanisms. 

In terms of central banks, the dovish 50-basis point hike from the Bank of Canada, instead of the expected 75 basis points, increased investors’ faith that the end of the hiking cycle is now finally coming into sight. 

In terms of equity market performance, despite a raft of negative headlines, was actually a week of gains for equity markets. The S&P 500 was up 3.4%, registering back-to-back weekly advances. The index is now up 8.3% in October. European stocks posted their best weekly advance since March. The STOXX 600 was up 3.7% over the course of the trading week. 

In terms of major events, at the European Central Bank meeting on Thursday, the Governing Council doubled up on the deposit rate with a second straight 75-basis point hike, after inflation surged to five times the target level in September. The central bank has now taken the deposit rate from negative territory, in early summer, to 1.5%. That’s the highest level since 2009. 

Despite the aggressive move and recession risk, the European Central Bank vowed to raise rates further, although the size of the hike wasn’t unanimous and the statement appeared less hawkish than it was in September. So, the pace of future moves is likely to be determined, we think, by the incoming data. Although, we do expect the European Central Bank to step down to a 50-basis point increase at the December meeting. 

The European Central Bank also reined in the pricing on its ultra-cheap loans, the targeted long-term refinancing operation, by raising the interest rates that banks pay on them. The move is designed to encourage the banks to repay those loans, rather than depositing the money at the central bank, where the rapid rise in interest rates is now allowing them to make a risk-free return. 

The European Central Bank said the next stage of policy normalisation, quantitative tightening, or the shrinking of its bond portfolio, will be up for discussion at the December meeting, but is unlikely to start until next year. 

So, that was the global economy and financial markets last week. In order to discuss the impact that international relations could have on investors over the course of the next year or so, I’m pleased to be joined by Andrew McDougall, Head of Geopolitical Risk at Barclays. 

Andrew, great to have you with us today. Let’s start off with the obvious. The war in the Ukraine, as we know, has sent a shockwave through the global economy and financial markets. It’s been described as the biggest security issue in Europe since the second world war. How do you see the conflict playing out from here? 

Andrew McDougall (AM): Thanks, Henk, it’s great to be with you today. I mean we’re in a very tense and fragile period, especially with the lead up to the winter months. It is not going to end any time soon, that’s for sure. I think Putin is cornered, his mobilisation, he has said, has finished, but it hasn’t had a great impact on the battlefield, and I think his real issue is if the Ukrainians push through Kherson and start threatening Crimea.  

If they threaten Crimea, and we did see the maritime drones hit the ships in Sevastopol on the weekend, but if they really threaten Crimea with strategic weapons, then I think Putin will be forced to act. 

We have seen him act asymmetrically with destroying the Nord Stream 1 and 2 pipelines and really concentrating on the electricity infrastructure of Ukraine. His main aims are to put as much pressure on Ukrainians as possible, so the civilian population, defend as well as he can in the east, and defend as much as he can in Kherson.  

As I said, if the Ukrainians were to break through and threaten Crimea, then he may look to destroy the dam, the hydroelectric dam, to delay Ukrainian forces, and then he may look to attack in other ways. 

I don’t think tactical nuclear weapons will be the answer. Only if Crimea is really under threat would he think about doing that, but he’s got lots of other weapons in the first instance. 

HP: So, you seem pretty pessimistic about the outlook in terms of the possibility of a peace treaty anywhere in the near future? 

AM: Yeah, I don’t think we’re anywhere near a peace treaty. There will be low-level negotiations ongoing. Both sides, Zelensky and Putin, need to get as much leverage as possible over the next few months. Zelensky wants to get as much land as he can, so he’ll be really pushing his military forces towards Crimea and maybe even open another front towards Mariupol, and then keep going into the Donbas.  

Putin, his leverage, he really wants to continue with that pressure on the Ukraine, but also the European Community. He’s got two main weapons, that’s grain and gas, and we’ve seen on the weekend that the grain deal has been suspended and what does that look like for the future? 

HP: Well, as you quite rightly point out, one of the major impacts of the conflict in Ukraine has certainly been in commodity markets. Europe has been desperately trying to reduce its reliance on Russian energy. How much progress have they made? How much of a risk is energy security in Europe over the course of the next 12 to 18 months? 

AM: Yeah, thanks, Henk. It’s the 12- to 18-month period that is the real issue. We’ve seen gas prices drop significantly over the last month or so, but, actually, it’s next year, and European storage next year that will be the real issue. There’ll still be tight supply, infrastructure’s still lacking, degasification plants. So, Putin knows this, and I think that will be a bigger issue next year. 

Grain, I think Putin cannot agree a new grain deal. It’s just a matter of how much leverage he can get in the short term, but I think next year, if the grain and his fertiliser is being exported, then I think that will be less of an issue. His main supporters, Egypt, Lebanon, China, really need this, so I don’t think it will be in his best interests. But I think energy is really that key. Gas, gas for next year, and whether Europeans can actually agree a price cap of any significance in the next few weeks. 

HP: OK. So, as you quite rightly point out, and let’s pick up on some of those points. Russia still has a market for its energy. They’ve been selling its gas and its oil to China and to India, a number of countries in Africa as well. Do you expect these countries to come under pressure to stop buying Russian energy? Will the international community consider sanctions on buyers for instance? 

AM: I just don’t think that’s a realistic prospect. I think the majority of the countries in the world support, or at least don’t actively go against, Putin. So, I just can’t see India and others being put under any form of sanctions, especially on oil. 

HP: As we know, Russia and Ukraine produce vast quantities of wheat, sunflower oil, and corn. It’s estimated between them they account for round about 10% of globally traded calories. Russia is the world’s largest producer of fertilisers as well, helping farmers around the world to improve their yields. So, what are the risks to food security from the disruption that we’ve been seeing caused by the war? 

AM: I think the real impact will be around any restriction of grain and fertiliser coming through the Black Sea, to increase prices, put real pressure on other markets such as Egypt and others. Egypt, itself, imports 80% of its grain from Ukraine and Russia, so it really needs that supply to continue, as with Lebanon as well, without significant storage they’re under real pressure.  

So, I think that restriction of any grain out of the Black Sea will be disaster. So, I don’t think Putin will, in the long term, delay if he can, any of that grain. And Turkey is a huge importer, one of the biggest importers of grain because they’re one of the biggest exporters of flour, and, hence, Erdogan’s connivance with the Russians. But I think he will really put pressure on Putin to continue that grain supply. 

HP: Andrew, have you been surprised by the solidarity amongst the international community for Ukraine? And perhaps what are the broader, longer-term conclusions that we should draw from the support that they’ve received? 

AM: Yeah, I think not only was I surprised, I think Putin was surprised, and that unified western response has been very significant, and I think other countries, such as China, are really looking at it as to see what might be the impacts or western response if something happened on Taiwan.  

But I think this is maybe a unique situation, because of the proximity to Europe and the impacts of energy and grain. So, I’m not quite sure that these sanctions, or the unified response and particularly the sanctions, will have that much of an issue with some of the other global events. 

HP: Well, you mentioned China and Taiwan. Certainly, when we talk to clients about the outlook one of their clear areas of concerns is, indeed, China’s intentions towards Taiwan. At the recent party conference, President Xi said that China will continue to strive for a peaceful reunification with Taiwan. He certainly fell short of renouncing the use of force. Do you think China will seek to take control of Taiwan using military force? And if they did, what would be the response of the international community? 

AM: I think Xi, now he has consolidated his power, has a bit more room to manoeuvre. He’s very clearly stated that, a) by 2027, the PLA will be ready to conduct any invasion. By 2035, he wants GDP per capita in China to be the equivalent of, say, a Spain or a mid-sized European country. And by 2049, the Greater China Project to be complete.  

Now, those dates seem well into the future. I think the likelihood of him conducting a military invasion of Taiwan is low in the short term, unless it was triggered by something like the Taiwanese declaring independence, which would necessitate an immediate response by Xi. But, in a way, he doesn’t want a military invasion. He wants to strangle Taiwan economically in the first instance, and over some time until he’s ready, and then, worst case, invade if there was no other option in the future. 

So, I don’t think anything in the next 18 months, two years. I couldn’t say nothing in five years, but I think we’re in an unknown period, but a military invasion is still an unlikely event. 

HP: OK. And the response from the international community? 

AM: Yeah, that’s the difficult question, because I don’t think we’ll have a unified western response like we saw against Russia. I think there’ll be a difference of views between Europeans and the US, particularly the Germans, and we’ve seen Shultz visit Beijing at the end of this week. So, I think we’ll be in a different situation. 

And I don’t think we will see those sanctions put immediately on China. What I think we will see is probably selected decoupling over the next few years, and we’ve already seen a start of that with the ‘technology war’ over semiconductors, which will probably increase. So, I think China knows this and I think the western response will be different and less unified. 

HP: So, let’s stick with China for just one more moment. Tensions, as we know, with the United States appear to be ratcheting up once again. Is this a further area of concern? 

AM: Yeah, definitely. I think it’s very difficult to see how it doesn’t escalate and the current sanctions and trade controls are one thing. What will the Chinese response be? And then how will US sanctions increase over the short term and medium term? I think that’s where it will start getting difficult.  

Remember, China controls most of the minerals or the refining capacity needed for batteries and semiconductors, and so we need that. What does that look like and what the impact will be is very difficult to measure at the moment. 

HP: Andrew, let’s finish off with Europe. As we look into 2023, we know there’s a broad range of both economic and political pressures that have been building up. What are the risks that these could develop into a further fragmentation of the Union? 

AM: Yeah, I think, actually, Russia and China will, or the events in Russia and China will, really manifest itself in European unity or disunity, and I think the next 12 months are really a key. We’ve seen the Germans for the first time under economic pressure and potentially unable to bail out the Union, and putting in unilateral energy subsidies has rocked Brussels and some of the other member states. 

So, I think we’re in a period of difficulty for the Union. We’ve got lots of elections coming. We‘ve seen the Italian and the Swedish electorate vote for centre-right and right-of-centre parties. That will probably continue. A few more nationalist governments may put more pressure on Europe.  

The European Union still has unanimity in the Council, so does that change, and do we end up having a split Union, whether it’s north/south or east/west? And I don’t think we’ll have the Germans as the backup that we did during 2011. 

HP: Well, thank you, Andrew, for your insight today. There’s no doubt that international tensions will continue to influence global growth prospects and returns for investors over the course of the next year or so. We will continue, of course, to monitor those situations very carefully indeed. 

Let’s move on to the week ahead, where the focus will once again be on central banks with rate decisions at both the Fed meeting on Wednesday and the Bank of England on Thursday. Elevated inflation and strong labour markets suggest the Fed will hike by another 75 basis points. Consumer price growth in September will remain robust at 8.2% year on year. Additionally, there are signs that inflationary pressures are becoming more broad-based and embedded. Remember, core CPI hit a 40-year high, 6.6%, in September, up from 6.3% in August. 

Despite the pace of inflation moderation being slower than expected, we still anticipate that the rate of price increases will continue to ease through the course of 2023, supported by a broad-based slowing of demand, high inventory accumulation, and an easing of supply constraints. Nevertheless, the upside risk from shelter, tight labour markets, elevated wage inflation, together with the uncertainties on food and energy prices, certainly makes it difficult to quantify the pace of disinflation. 

In terms of the outlook for inflation, we are confident that peak US inflation is now behind us and the readings will slowly grind lower from here over the course of the next 12 months. For example, we expect headline CPI of 6.8% year on year in December, before driving down to 2.5% the end of 2023. 

We do think that the Fed hiking cycle will finish forcefully. We expect the Fed to raise rates by a further 75 basis points at the December meeting, making it five consecutive meetings of three-quarter point increases.  

As we enter 2023, we expect the FOMC to ease the pace with a final 50-basis point hike in February, as risks between inflation and growth begin to level out. This suggests the terminal point for the fed funds rate for this cycle will be at 5% to 5.25% in the first quarter of next year. 

At the Bank of England meeting on Thursday, we’re also expecting a 75-basis point increase. The Monetary Policy Committee has had a particularly difficult task in assessing the appropriate level for rates. Beyond the obvious challenge of double-digit inflation, the MPC has also had to digest the turmoil that we’ve seen in the UK financial market and those wild gyrations in government policy. 

Given the struggling of the UK economy, the tighter fiscal stance, and taking into consideration that base rates are already in restrictive territory, we believe that policymakers will conclude the hiking cycle at the December meeting.  

So, after delivering this bumper 75-basis point increase on Thursday, we expect a final 50-basis point increase at the end of the year, leaving the terminal rate at 3.5%. However, given the vast amount of economic and fiscal uncertainty, we should acknowledge that risk to rates still remains very much skewed to the upside.

And with that, we’d like to thank you once again for joining us. We hope that you found this update interesting. 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. 

(end of recording)