Markets Weekly podcast – 22 August 2022

Henk Potts (HP): Hello. It’s Monday, 22^nd August 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 consider the dynamics of inflation and the impact on portfolio positioning. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Equities struggled to maintain their recent upward trajectory last week as investors continued to worry about weakening economic positions, elevated inflation prints, and tightening financial conditions, although a hope of a peak in price pressures in the months to come and solid corporate earnings help to limit some of the losses.

Market performance, well, the S&P 500 snapped the four-week winning streak, registering a decline of 1.2%, but after a miserable first-half, the benchmark US index is 16.3% above its low on 17^th June. In Europe, the STOXX 600 fell eight-tenths of 1% over the course of the week, and is 9.3% above its low on 23^rd June.

The second-quarter earnings season has provided support, with companies indicating that demand has been robust enough for them to pass on increased costs. Eighty seven percent of US and European companies have now reported earnings. Around three-quarters of S&P 500 companies have beaten analysts’ estimates, while the figure in Europe is around 50%, according to Bloomberg data.

While equities have displayed a more positive tone over the course of the past five weeks, US bond markets continue to signal fears of recession, with the yield curve remaining inverted, the yield on the benchmark 10-year Treasury note standing at 2.98% while the 2-year yield is hovering around 3.26%.

In the UK, investors were bracing themselves for another red-hot CPI print and the report didn’t disappoint. UK inflation surged into double-digit territory for the first time in four decades. CPI hit 10.1% year-on-year in July, that’s up from 9.4% in June, which was both ahead of consensus and the Bank of England forecast.

UK CPI is now more than five times the targeted level. Rising food prices, up 12.7% year-on-year, made the largest upward contribution to the change in the CPI annual inflation rate. Food prices have been pushed up by the soaring price of energy, packaging, and animal feed. Output prices rose 1.6% on the month and by 17.1% from a year earlier, the largest annual gain since 1977.

The core inflation reading, which, remember, excludes food and energy, was, perhaps, more disturbing. Core CPI accelerated to 6.2% in July, substantially above the expected 5.9%.

In terms of the policy outlook, the forecast that UK inflation will hit 13% in October will encourage the Bank of England to raise rates into restrictive territory with that 50-basis point increase in August. Our base case suggests one further rate hike of 25 basis points in September, taking the base rate to 2%.

However, the robust inflation report, coupled with signs of stronger underlying wage growth in the June labour market report, has significantly increased the risk the MPC will vote for a 50-basis point hike in September. After the September meeting, an easing of inflation expectations and faltering growth profile should take some of the wind out of the Bank of England’s tightening sails.

In terms of the broader outlook for global inflation, we do believe that inflation prints will still peak over the course of the coming months as tighter monetary policy moderates demand, commodity prices stabilise, inventory levels, remember, are elevated, which take some of the pressure off the goods category, and an easing of restrictions and an increase in capacity help to resolve summer supply constraint, although we’ll be watching China as it continues to pursue that zero-COVID strategy very carefully in that regard.

Another reason, I think, to be optimistic around the outlook for inflation is a lack of a severe wage-price spiral playing out. Wages have been rising, but the increases have remained substantially below inflation. So, these elements, along with a range of technical and statistical factors, have encouraged us to estimate that global consumer price pressures will diminish from their current levels to average 3.6% in 2023.

And that’s good news, because an easing of inflation expectations should help to take some of the intensity out of the hiking narrative that’s been dominating the headlines and markets over the course of the past year or so, allowing policymakers to orchestrate a softer economic landing than many economists are currently predicting.

In the US, the focus was on retail sales, housing starts, and the Fed minutes. Retail sales flattened in line in July, which was better than expected following a revised 0.8% gain in June. The headline number, as we know, was dragged down by a weakness in cars and gasoline prices.

I think we need to be a little bit cautious about the resilience that’s been expressed with the report though. Sales were probably flattered by the Amazon Prime Day. A robust performance in the online category is likely to be unwound in August. Worryingly, sales of clothing and general merchandise registered an outright decline.

In terms of the outlook for consumer spending, strong labour markets and excess consumer savings have helped to cushion demand. Both consumer confidence and retail sales are showing signs of anguish against a backdrop of elevated inflation and those tightening financial conditions, which, as we know, doesn’t bode well for growth prospects in the United States.

Meanwhile, the warning signal from the US housing market also continues to ring louder. This is after data showed total starts of single- and multi-family homes fell by a much-worse-than-expected 9.6% in July. This continues a downward trend of housing starts and is now its lowest reading since March 2021.

A range of datapoints, including starts but also sales and permits, are expressing the stress in the US housing market, as underlying conditions have dramatically deteriorated as buyers and developers react to elevated prices and higher mortgage rates. Thirty-year mortgage rates in the US have been hovering around 5.5%, which is the highest in more than a decade.

On the policy front, the Fed July minutes went further in acknowledging the downside risk to activity, but fell well short of any sign of a pivot away from the need to curb inflation. The Committee still views the risk of sustaining inflation warrants further tightening in order to bring policy to a restrictive stance by year-end.

To remind you, we forecast the FOMC will step down to a 50-basis point hike in September, followed by 25-basis point increments in November and December, putting the target range at 3.75% to 3.5% at year-end.

In terms of the growth outlook, a weaker consumer, slumping housing market, higher interest rates has encouraged us to become more sanguine about the growth prospects in the United States. We forecast growth in the US economy will slow from an already downgraded 1.6% during the course of this year to just 0.6% in 2023.

So, that was the global economy and financial markets last week. In order to discuss the impact of elevated price pressures on portfolios, I’m pleased to be joined by Lukas Gehrig, Quantitative Strategist for Barclays Private Bank.

Lukas, great to have you with us today. You’ve been looking into the recent inflation dynamics through the quantitative lens and comparing them with the oil shocks of the 1970s. So, my first question is, how comparable are these two periods?

Lukas Gehrig (LG): Henk, it’s great to be here and hello dear listeners. It’s a good question, because actually there are many good arguments to give for, or against, this comparison to the ‘70s.

The biggest ‘pro’ argument is really the nature of the shock, because, in its origination, such an oil-price shock has nothing to do with the economic cycle. In fact, the ‘70s oil shocks came out of already cooling US economies. On the contra side, you have the way that monetary policy was conducted back then, which is quite different from how it’s done nowadays.

And also, well, the oil dependency of production has changed quite a lot from the ‘70s to now. For us, however, it’s really the exogeneity of the shock that is key, because that is nothing like that build-up of inflationary pressure that you would see over a cycle.

So that’s why we believe that the understanding of inflation dynamics, that we have built up over the last four decades, may not be that helpful in understanding today’s shock than actually looking back at the ‘70s and understanding these oil-price shocks.

HP: Well, thank you for setting out the background and giving us those pointers. It’s certainly understandable why your interest has been sparked by the events of the 1970s. Can you explain to us in very simple terms, if you would, the process that you have been following?

LG: Yes. So, for us the goal was to understand these dynamics of the ‘70s oil shocks. And by dynamics, I mean understand the interplay between different sets of prices and the economy. Now, one could use man-made aggregates, like what you’re citing often here, the headline inflation, core inflation, energy component, but we believe that this would be drawing away lots of valuable information that lies underneath. So, instead, we decided to let the data speak for itself.

And to this end, we collected data on 23 sub components of the consumer price index in the US. Think of things like prices for piped gas, prices for food away from home. So, we took 23 of these price series and we ran them through something that we call a dimensionality reduction technique.

Now, in essence, what this is doing is, this is boiling these 23 series down to just three factors that explain most of the variability that is in there. So, we can then look at these three factors, look at their composition, their drivers, and name them accordingly. The first factor, the most important one, we call a cycle factor. The second one, a fuel factor. And the third one happens to be related to public services.

HP: OK. So, what did you find in your analysis for the 1970s that you believe can be carried over to today’s situation?

LG: Yeah, the 1970s data showed a really clear pattern of having first a shock to the fuel factor, then followed by a search in the cyclical factor, and the period in between the two peaks ranged something between six to eight months. Interestingly, the peak of the cyclical factor always coincided with the strong rise in the unemployment rate.

Now, if you take this to the 2020s, we were off to a similar start. Given the last prints, we expect that the fuel factor may have peaked back in May, and the latest inflation report suggests that already in June, there may have been a peak of the cyclical factor. But now, keeping in mind that the ‘70s experience with this period of six to eight months and what you’ve just said in the beginning of this podcast, the inflation dynamics that we see right now in Europe, we would remain very sceptical and cautious about calling inflation under control or at bay for now, at least until we see a clear rise in the unemployment rate in the US. And in this regard, the latest labour market report for the US has still been showing a downward trend in the overall figure.

HP: Lucas, we know investors should be prepared for markets to be dominated by inflation news for some time to come. What are the key implications for portfolios and what action can investors take to try and mitigate some of the risk?

LG: Yeah, we believe that inflation certainly will remain the predominant topic, but for investors, it’s always important to keep the bigger picture in mind, so we cannot forget about growth and monetary policy.

And in this regard, we recently looked at the correlation of broad asset classes, like, for example, equities, to major macro factors, including growth, inflation, and monetary policy. But we didn’t just look at pure correlations. What we looked at was partial correlations, and partial correlations allow us to describe the relationship of, say, equities to just inflation, while filtering out all the interference that we will get from growth and monetary policy.

That is something that is often overlooked with the relationship between asset class performance and macro factors we studied. So, interestingly, only one asset class really fared well in a scenario where we had high inflation, low growth, and restrictive monetary policy. And that asset class happened to be precious metals.

The greater commodity complex is very cyclically driven, so hurts from low growth, whereas equities and risk-on assets in general, yes, they can cope with inflation but only as long as growth and monetary policy remain equally supported.

So, to sum it up, our takeaway is not right now to try to get cute with market timing, because you have just addressed this in this podcast last week. Market timing can be extremely difficult. You don’t only have to get the exit points right but also the re-entry. Instead, we believe that now is a good time to consider portfolio hedges or establish some. And for such a scenario, with low growth, high inflation and restrictive monetary policy, precious metals do look like an attractive hedge.

HP: Well, Lucas, thank you for sharing your analysis on inflation, the impact it can have on portfolios, and, perhaps most importantly, offering some practical steps investors can take to try and reduce the risks associated with it. This is no doubt stuff that we will continue to address in the coming months.

Let’s now move on to the week ahead where the focus will be in the US on the messaging emerging from the Jackson Hole Symposium. Fed chair Jerome Powell is scheduled to speak on Friday where he’s expected to guide policy to a moderate restrictive position in the coming months, while highlighting the importance of data dependence and risk management.

In Europe, the European Central Bank will publish the minutes of the July Governing Council meeting, which are likely to reiterate the need for policy normalisation given the persistence of elevated inflation. Eurozone inflation is now expected to stay above 5% till June 2023.

On the data front, elevated inflation, that cost of living crisis, is expected to drag down both business and consumer sentiment. We look for the August composite PMI to fall deeper into contraction territory and the euroarea consumer confidence to print at a record low, -27 for July.

And with that, I’d like to thank you once again for joining us. I 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.