Markets Weekly podcast – 14 February 2022

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

As usual, we will start this podcast by going through last week’s main events in markets, and what they mean for investors. For our guest segment I’m thrilled to be joined by Fabrice Montagné, Chief UK Economist at Barclays Investment Bank, to discuss the inflation and growth outlook in the UK, as well as the Bank of England’s next move.

But before that, let’s spend a few minutes on last week’s main events, the upside surprise to the US consumer price index. The CPI came in at a 40-year high of 7.5% year over year in January, three-tenths above consensus expectations. On a month-to-month basis, prices jumped 0.6%, again two-tenths above consensus.

Stripping out energy and food, core CPI was up 6% year over year, and 0.6% month over month. Food, electricity, and shelter were once again the top contributors to inflation, and while goods inflation remains stubbornly elevated, the real surprise came in from the cost of services, which increased more than 4%.

The market initial reaction wasn’t surprising, however, with yields spiking and the 10-year government bond yield briefly reaching 2%, while equities came under some pressure. However, that move was quickly reversed as investors started dissecting the CPI, noting that food and energy drove a lot of the upside, while used cars and shelter both rose month on month, but at a slower pace.

At this point, equity markets came back into the green, just to be pushed right back down by President of the St Louis Fed James Bullard, one of the most hawkish members of the FOMC, who said, on Thursday, that he would like to see, and I quote, 100 basis points in the bag by 1^st July, and that an emergency and immediate hike of 25 basis points should be considered on the back of the stronger-than-expected CPI print.

This extremely hawkish stance was later contradicted by other FOMC members, however, who expressed a reticence to be too aggressive. Yet, the damage was done, and the market is now pricing in more than six hikes in the US in 2022, with more than a 50% chance of a 50 basis point hike in March.

On our side, we remain of the view that these assumptions are probably too aggressive. While the Federal Reserve will hike interest rates, we believe it will do so just as it said it would, ie remaining nimble. And if, as we expect, inflation pressures are starting to abate by the middle of this year, we believe the Fed could take a more prudent approach, especially if the central bank is reducing its balance sheet at the same time.

Now the main other topic of last week was the rising tension between Russia, Ukraine, and the West. After some initial optimism, following the visit of French President Macron to Russia and his talk with Vladimir Putin, the situation took a turn for the worst on Friday, when several countries called for their citizens to evacuate Ukraine as a Russian invasion was imminent.

It has been imminent for almost a week now, and the situation remains extremely fluid. Today, Monday, Germany’s Chancellor will travel to Kiev, and tomorrow, on Tuesday, to Moscow for another round of talks. But hopes for a diplomatic breakthrough aren’t that high.

While a full-on, and therefore global, conflict is certainly not priced in at the moment, these tensions have already led to some risk-off moves. The Russian five-year CDSs are back above 200 basis points and the rouble is about 75 versus the US dollar.

These are the type of binary black-swan events that are almost impossible to predict, and this is why investors fear them so much. In addition, the main, and probably the most likely, risk here is not a war, per se, but the possible impact that this conflict could have on energy prices and the ramifications with regards to inflation expectations globally.

And while we can’t take realistically any sort of view one side or the other, we know that geopolitical tensions are rarely something that have a long-lasting impact on markets, especially outside of the regions that are involved in that conflict.

Now, if we use the Iraqi invasion of Kuwait back in 1990 as what still is a lousy comparison, back then the S&P 500 dropped around 17% in the following two months. However, within less than six months it had recovered all of its losses. This is an example of how markets tend to react to geopolitical events.

That is it for last week’s wrap up. Let’s now move on to our guest segment. And, Fabrice, a very good morning. I’m very happy to have you with us today.

We’ve talked a lot about the US when it comes to the inflation and the rate outlook just now, but the UK isn’t in a much different situation. If anything, the country is probably under even greater pressure. So, can you walk us through what you’re seeing in the UK on the inflation front?

Fabrice Montagné (FM): Good morning, Julien, and thank you very much for having me on the show today.

Listen, I don't know if the UK is in a worse place. You know, the grass is always greener on the other side. The fact is that we also are going through a stress of our own. Yes, inflation, so inflation is front and centre early this year, much because of the same reasons than elsewhere, precisely because we’re printing levels that we haven’t seen in decades, right?

However, I think the comparison stops there, because what really matters for inflation is the composition of inflation. Where does it come from?

And I think in terms of the mix here, we are in a very different situation than the US. The US has inflation driven by energy, of course those are global prices, but also by domestic inflation. They are overspending on goods, and goods prices over there are increasing very, very fast.

Now, interestingly, goods prices also increase in the UK, and they account for a large share of inflation, but it’s not like we are overspending on those goods. These goods prices, what we call global goods, are set at a global level, and we import this inflation from inflationary pressures generated elsewhere. And that’s a very important distinction because much like energy, for instance, where energy prices are also set on a global level, there’s little we can do here to avoid this kind of inflation, right?

So, I think what you need to have in mind is that like out of those, how much it will reach, five point something in December, we’re likely to have similar levels, you know, early this year, and even higher in April, when the energy regulator Ofgem increases the energy cap price by something like 50%, even a bit more. So, we’re going to have another round of high inflation, but out of this, call it 6-6.5% inflation that we forecast, 2.5% are due to energy, and something like 1-1.5% more is due because of global goods.

So, we can confidently say that in the UK most of the energy we’re facing is imported. Now, the “most” here does the heavy lifting, because what we’re seeing as well is domestically generated inflation, as we call it, picking up, right? And most strikingly, service price inflation has reached levels we haven’t seen in a decade.

Now, those are not levels incredibly high, right, but those are levels that 15-20 years ago we could accommodate because we were importing deflation from goods. Remember, a decade ago, China was massively exporting deflation, and we could afford running higher domestic inflation because that was offset by other factors, and that’s not the case anymore.

So even though service price inflation is still very contained, it is on the rise, and it is not offset by other indicators. What we also have noted since November, and December confirmed that view, is that inflation pressures have been broadening. It’s not only a couple of goods explaining all of the excess inflation, it’s now more and more goods explaining higher and higher inflation, right? And that’s where it gets uncomfortable, because that’s precisely what a central bank wants to avoid, right? And we’ll come back to that a bit later.

A couple of other things I’d like to highlight. How do you forecast inflation at this stage? Well, as you could observe it you do it very poorly. We, as in the, you know, the forecasters community, did miss most of the inflationary wave over the recent months, and we have been consistently surprised on the upside.

So that means that we are not fully understanding a lot of that wave that’s coming through and how much of momentum we’re actually facing. And that will likely stay with us until we peak, right? And we will peak one day, the question is will we peak at 5, 6, 7%?

Now, on that front we have to take into account, you know, some technical factors, seasonals, mean reversion, base effects etc that will start kicking in early this year. And to give you one example, a year ago the restaurants and accommodation sector in general was reversing a VAT cut.

So we had prices a year ago in the sector increasing faster than they usually do, and that base effect, how we call it, should contain the annual increase in prices early this year, because unless prices this year also increase faster than they would, you know, if you would be reversing a tax effect, we should get a lower annual pace of growth in those sectors.

And when you forecast you have to consider these, and you also have to consider mean reversion. I mean look at energy prices. They go up, but then they also go down. Another item that’s really telling is second-hand cars. I mean second-hand cars and cars in general were, at least in the measure produced by the ONS, were flat for most of the past 20 years and increased between 20% and 30% over the past two years.

Now, this level shift is amazing, right, and it’s something we usually don’t see. I mean prices evolve within a couple of percentage, not within 20-30%. We don’t have any theory in economics that will explain why the price of cars will remain so elevated. The only theory here is, obviously as you have read it a bit everywhere, is supply-chain disruptions, chip shortage, etc.

But as those shortages ease, and we do pick up some signs that, you know, it is easing, at least it’s not getting worse, you know, in any way. But as those pressures ease, we should see more and more cars, new cars, coming to the market, and we should see second-hand cars coming under pressure, right? And when they do, we will be generating quite a lot of, you know, at first disinflation and maybe deflation from that particular item.

So putting everything together, right, we should see in the early months of this year, oh, one factor that I’d like to mention, by the way, is pricing power, and you sense that, you know, going into Christmas, businesses have likely more pricing power, especially retailers. But coming out of Christmas, in January, February are usually very slow months, it is likely more complicated to keep on increasing prices, because people are way too happy to turn away from spending, right, in those early months. So that’s also something to keep in mind.

So when you wrap up everything together, we should peak, you know, sometimes in the early months of this year. We’ll get another hike of energy prices in April and from there it could go fairly fast depending on how things evolve. But that’s, you know, one of the risks, and the Bank of England has talked a lot about that. You know, what happens when things turn around all at once? Well, we’re kind of forecasting, to some extent, that we might be touching 1% sometime next year, right, so those are the kind of risks that we’re having.

JL: Yeah, that is the next question that I wanted to ask you. So obviously, as per your inflation outlook, higher inflation in the short term, potentially lower inflation down the road, so what does that mean for the BoE? The Bank has already hiked twice. Shall we expect much higher base rate going forward, maybe even a reversal after that? How do you see this playing out?

FM: Yeah, so the Bank of England is in what it calls a very uncomfortable policy trade-off. It has to face an acute short-term inflation shock, and it is risking a medium-term to longer-term, not outright recession but call it, you know, softer growth or, you know, higher unemployment, all else equal, right?

So it is trying to find the right balance between, you know, reacting to inflationary pressures. Most of them, as I highlighted, are generated elsewhere. But at the same time, it doesn’t want to generate a recession at home, because once global inflationary pressures turn around, or ease for that matter, it might be left with, you know, low inflation, low growth, high unemployment, and that’s something everybody wants to avoid.

So I think here one important thing to consider is the global trend, I mean because inflationary pressures, most of them are generated at a global level. It’s important to see what other central banks are doing.

I think in January we had like 30-something policy meetings, a majority of those generated a hike. It was something like 16 meetings. Most of others went for the status quo, and we had the Fed in January for instance, and only three central banks cut interest rates. So that gives you where the global trend for monetary policy is, and as that gains momentum, we should see a more restrictive stance on the global level, which means that, all else equal, the Bank of England might have to do less.

Now, the Bank of England is also in that situation. It started early after all. I mean what looked like, you know, a little bit of a gamble, I mean if you had asked me in December whether it’s wise to hike into Omicron, I would have said no, definitely not. But the Bank did, and now two months later, it actually looks like the right call.

Omicron turned out to be fairly mild, and not a disturbance when it comes to growth and inflation, which means that now the Bank of England is in this position of having started to tighten early. And when I say tighten, I don’t only mean rates. Yes, it hiked twice now. It also ended quantitative easing. So while, you know, the Fed or ECB are still buying month-on-month bonds, the Bank of England is not, it’s actually already starting to wind down its balance sheet.

So it is ahead of others, and when it comes to how much do you need to do on rates to counter what you’re seeing domestically, our take on this is not that much, right? You do have to address some tentative signs that service price inflation is increasing. You have to make sure, and here I’m quoting the Bank of England, you have to make sure that this global inflationary shock happens in the UK in a way that is consistent with price stability, ie inflation at 2%.

So you have to make sure that households do not expect inflation to be permanently higher. You have to ensure that, you know, whatever wage negotiations happen, they happen in line with productivity trends, in line with longer-term expectation of inflation at 2% etc, etc.

So it has a lot to do with communication, a little bit to do with tightening, and it means, in our view, that once you reach 1% rates you should be able to pause and observe what’s happening.

Now, the way to 1% is, in our view, fairly quickly, and that has to do with the speed of everything we’re seeing on inflation. So we see the Bank hike back to back between basically December and May. So we just had December and February. We’re expecting March and May another two hikes of 25 basis points, and then you reach 1%.

And just another word on this, once you reach 1% the Bank kind of said it might be using active quantitative tightening, which is actively selling bonds out of its portfolio, which is another way to tighten monetary policy, in addition to something we’ve seen as well in December, increasing counter-cyclical capital buffers which is yet another way, a macroprudential way to tighten policy, right?

So the Bank is playing on several different dimensions, has started to hike early, and we think it will allow to end the hiking cycle on rates early, at least much earlier than the market thinks. And I will leave you with this number, is that the market is playing with the idea of rates at 2% next year, so another four hikes after May, and we think that is kind of excessive, yeah.

JL: Great. Thank you. Thank you so much, Fabrice. Always great to get your insight on the UK economy, where definitely there is a lot happening at the moment, and we will certainly get you back on the podcast in the coming weeks as the situation evolves.

Before we conclude, I just wanted to take a quick look at the week ahead. The narrative shouldn’t actually change too much, all eyes will remain on Ukraine, while from a macroeconomic perspective we’re expecting a lot of inflation data, starting with the US PPI, followed by China’s CPI and PPI. We will also get, as Fabrice just mentioned, the UK inflation data on Wednesday as well as US retail sales.

And finally, the FOMC meeting minutes, which should hit on Wednesday. And these minutes might be the most relevant data point of the week, as investors will be keen to get any clue from the Fed as to whether quantitative tightening, which is, as Fabrice mentioned, already happening in the UK, is coming to the US and at what pace. Although Jerome Powell said this wasn’t really discussed during the last meeting, there could be some mention in the minutes, and this is a critical topic at the moment for markets, and clearly this could result in some volatility midweek.

In any case, investors should be prepared for turbulent times ahead, and, in this context, we remain of the view that maintaining composure is key, and are focusing on the long-term outlook which, in our view, remains favourable and is very important.

With that, let me wish you all the best for this week. For those celebrating it, a very Happy Valentine’s Day, and we’re looking forward to sharing our views again next week. Thank you.