Markets Weekly podcast – 27 February 2023

Henk Potts (HP): Hello it’s Monday, 27th February 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 will then consider the ongoing impact of the war in Ukraine as we pass the one-year anniversary mark. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead. 

Equity markets continued to drift lower and bond yields rose last week as concerns intensified that inflation will remain elevated for longer, forcing central bankers to remain hawkish as the fight against price pressures goes on.

In the US on Friday, investors were waiting to see if the strong run of datapoints would be reflected in the personal consumption expenditures report, which covers household income, consumer spending and the FOMC’s favoured inflation indicator, PCE price inflation. And the answer, you have to say, was a resounding yes. The PCE price index increased six-tenths of 1% month-on-month, the biggest rise that we’ve seen since June. Year on year, the index was up 5.4% in January. The core reading was up 4.7%, both of which were faster than the previous month.

In terms of personal spending, well, after adjusting for changes in prices, it still jumped 1.1%, the largest advance since March 2021, following the weakness at the end of last year. The increase reflected stronger demand for both goods and services.

The pick-up in income growth, you have to say, was more muted than expected, though personal income growth still accelerated 0.6% in January from 0.3% in December, but that was below the 1% that economists had predicted. 

So, what does this mean for markets? Well, we know that global equities have rallied aggressively through the course of January on expectations that inflation would rapidly decelerate as demand moderates and that the hiking cycle would be concluded in the early part of this year. It now appears that price pressures are taking longer to resolve, consumer demand is holding up better than expected and the hiking cycle will stretch out into the middle of the year, all of which have sapped some of the momentum out of the equity market recovery.

In terms of the stock market performance last week, well, the S&P 500 registered its worst weekly sell-off since early December. The benchmark index fell 2.7%. In Europe, the STOXX 600 was also down, it was down 1.6% last week. In terms of bond markets, well, Treasury yields jumped on Friday. The policy sensitive two-year yield rose to 4.8%, its highest level since 2007, as traders increased the probability of a 50-basis point hike in March by 41%. We still think, on the balance of probability, the US central bank will still hike by 25-basis points but it could be a closer call than was originally anticipated.

Moving on to Europe, where economic data continues to be more resilient than expected, suggesting a technical recession could be avoided but elevated, inflation is keeping the pressure up on the European Central Bank.

Fourth-quarter growth came in better than expected. Consumer demand in Europe’s been holding up. Confidence levels have been improving. Also, Chinese demand for European products should increase as the economy reopens and international travel resumes.

Data last week showed the euro area composite PMI survey rose to 52.3 in February, from 50.3 in January. That’s its highest level in nine months and safely above that 50 expansion line driven by an improved performance in the service sector and the return to growth in manufacturing output.

S&P said the activity increased due to rising demand with the pick-up in the new orders, healing supply chains, order backlog reduction and an increase in business confidence. Within the euro area, both France and Germany returned to growth for the first time since last October.

Falling energy prices have also been taking some of the pressure off disposable incomes and improving sentiment. European natural gas futures settled below €50 a megawatt hour for the first time in over 17 months last week. Futures are down around 80% from their August peak. 

So, we have upgraded the European outlook. We think it now goes from recession to stagnation, with growth of four-tenths of 1% during the course of this year, 0.8% in 2024, which is certainly better than the contraction that was feared, but still pretty anaemic, growth.

Eurozone inflation, as we said, continues to be a problem for policymakers. Price pressures in the eurozone rose slightly more than estimated. CPI rose 8.6% in January, although has still fallen from 9.2% in December and has decelerated for three consecutive months. More of a concern, I think, for policymakers will be core prices, which rose to a record 5.3% year-on-year last month, suggesting that those inflationary pressures are, indeed, becoming more embedded.

In terms of the policy outlook, well, you’ll remember at the February meeting, the European Central Bank effectively preannounced a 50-basis point hike for the 16th March meeting. European Central Bank President Christine Lagarde reiterated that projection over the course of the weekend. 

Beyond that meeting, given the improved economic outlook, we would expect the European Central Bank to continue to raise rates into early summer, but step down to 25-basis point increments in May and June, with the deposit rate settling at 3.5%.

We think the pivot to an easing stance may take some time to come through, but we currently think the European Central Bank will deliver 100-basis points of cuts in the second half of 2024 and project a 2.5% deposit rate at the end of next year.

Whilst the macro news has certainly been dominating sentiment, the fourth-quarter earnings season is coming to a conclusion. Ninety four percent of S&P 500 companies have now reported their results. According to FactSet data, 68% have come in and reported a positive earnings per share surprise, while 66% reported a positive revenue surprise. It has to be said, both are below the five- and 10-year averages.

For the fourth quarter, S&P 500 earnings look set to decline 4.8%. If 4.8% is the actual decline for the quarter, it will mark the first time the index has reported a year-on-year decline in earnings since the third quarter of 2020.

Five of the 11 sectors are reporting year-on-year earnings growth, led, as you’d expect, by energy and industrial sectors. Conversely, six sectors are reporting a decline in earnings, led by communication services, materials and consumer discretionary sectors.

In terms of the outlook, analysts expect S&P 500 positive earnings growth to return in the second half of this year. With calendar year 2023, analysts are projecting earnings growth and revenue growth of 2.2%, which may still look a little bit optimistic given some of the pressures that we have been seeing in terms of margin. What we don’t expect is a deep earnings recession to play out.

So, that was the global economy and financial markets last week. In order to discuss the war in Ukraine and its ramifications for international relations and the markets, I’m pleased to be joined by Andrew McDougall, Head of Geopolitical Risk for Barclays.

Andrew, great to have you with us once again. When this conflict started, there was an expectation, at least on President Putin’s side, that it would be a relatively swift war and control of Ukraine would be quickly established. Given we’re now going into the second year of hostilities, this clearly has not turned out to be the case.

So, to start with, could you update us on the current state of the war, and which side has the best momentum?

Andrew McDougall (AM): Yeah, thanks very much, Henk. It’s great to be back. Yeah, the Russians, at the moment, have started their long-awaited counter-offensive to take back territory they lost last year. They’re concentrating their offensive around the Luhansk and the Bakhmut region and really pouring as many troops as they can into the region to try and take back that territory.

So, their objective is to, as you know Putin annexed the four provinces, to take that back as quickly as possible before the Ukrainian forces are able to take advantage of the Western equipment, in particular the tanks with the trained crews, and then they start their own offensive in the spring.

HP: So, when we look at it, Vladimir Putin’s objective hasn’t really changed compared to where we were a year ago?

AM: Yeah, I think that’s right. He’s been very flexible. Once he formally annexed the four oblast provinces, I think his objectives then were reduced. So, he didn’t want to take the whole country, he just wanted to take those four areas. So, he’s quite flexible. I don’t think his objectives can be reduced anymore, so I think he’s now set himself some clear goals.

HP: Andrew, we know that international sanctions have hurt the Russian economy. What we haven’t seen is the collapse that was once predicted, and sanctions certainly haven’t proved powerful enough to cause a change in policy. So, what level of support is there for the war in Russia and what are the chances of President Putin being removed from office as a result of the invasion?

AM: Yeah. Firstly, I think there’s very little chance of Putin being removed from office, at the moment. Seventy percent of the population supports Putin and the war. He controls the narrative. He controls the media. So, I don’t think there’s any chance that will happen.

If it did happen, if he was deposed, then potentially his replacement could be much worse, because he could be weaker and want to prosecute the war more aggressively. But economically you’re right, the sanctions haven’t worked as well as hoped yet, but potentially we’ve got the tenth sanctions package being agreed, or argued about, in Brussels at the moment with some Polish and Hungarian vetoes or issues at stake. But I think it will take more time for some of the wider sanctions to have an impact, but they will. At the moment, even the oil price caps, and others, aren’t really denting his economic strength.

HP: Two of the main reasons I think, why Russia has not been able to overrun Ukraine have been the incredible resolve of Ukrainian armed forces and the support of the West. Do you expect both of these factors to continue?

AM: Yeah, we shouldn’t underestimate the battering that the Ukrainian army has taken over the last 12 months. I mean they do have the morale, the motivation, the moral component that’s needed to be successful in warfare. But I think it’s the Western support that has really kept them going and supported them.

How long that will continue I’m not quite sure. In 2024 we have a lot of elections, Russian elections, US elections and a lot of European elections. So, I think the support needs to come as quickly as possible now, and Zelensky has certainly been on a charm offensive throughout Europe to really make sure that equipment gets delivered sooner rather than later. And when I mean equipment, I mean tanks, long-range rockets and missiles and, obviously, he wants the F16s in the future.

HP: And what chance do you think there is that he will, indeed, receive the air support that he’s looking for?

AM: Yeah, quite likely, but the problem is it takes a long time to get trained crews for F16s and other fighter planes. So, in effect, I think it’s actually for the long-term security of Ukraine and I don’t think it will have an impact in the next six months. And, as I said, the Ukrainians really need that support now, to have a chance, militarily, to take back their land, and if they do have the equipment I think they have a good chance of a successful counter-offensive.

HP: So, that’s one of the interesting points that continues to play out, and one of the elements that some leaderships have been talking about is the backfilling option, where they receive MiG jets from regions such as Poland that they’re more used to being able to use and, therefore, would be able to get to that position in a smaller timeframe than currently being predicted if they were to rely on the American jets. Does that seem reasonable?

AM: Yeah, it does seem reasonable, but I don’t think it’s politically reasonable. And what I mean by that is, if the Ukrainians have jets, if they have the ATACMS, so the long-range missiles, that enables them to directly target Crimea. It allows them to directly target targets within Russia itself. And that then plays to Putin’s narrative that Nato is attacking Russia, the Ukrainians are actually attacking the Russians, and that’s a dangerous position.

HP: OK. So, the West remains supportive, at least in the short term, but what role is China playing? They have appeared to be politically, diplomatically and economically supportive of Russia. Is this really the case? And over the course of the past few weeks there have been rumours that Beijing could be looking to broker a peace agreement. Is that a realistic possibility?

AM: Yeah, it is. And we’ve just seen the Chinese announce their 12-point plan for peace. It’s quite pro-Russian. It certainly doesn’t hold any punches against the US. They’ve always said that it’s the US, not China, that’s been pouring weapons into the battlefield and pouring fuel onto the fire, for want of another phrase, and so the US is in no position to tell the Chinese what to do. 

So, I do think the Chinese are certainly backing the Russians. They don’t want Russia to lose catastrophically, but at the same time, they don’t want Russia to win emphatically and be the power in Asia again. So, in a way, China wants it to be stabilised. They don’t want any nuclear responses by Putin, so they will certainly put pressure on the Russians in that way. But China quite likes having the US looking at Russia rather than at Taiwan.

HP: As confirmation of the war hit the headlines, it, of course, sent a shockwave through global financial markets, particularly in terms of commodity markets. However, as we’ve been discussing this morning, European energy prices have fallen dramatically from the peak in the summer. Are traders right to believe that energy and grain supply risks have disappeared?

AM: I mean firstly on energy, I think Europe’s been incredibly lucky with the mild winter to enable them to refill their storage tanks. I think they’re over 60% at the moment. But that doesn’t solve the infrastructure problems, and I know the Germans are building as many energy facilities as they can as quickly as possible, but we still have next winter as a critical winter. 

But at the moment we may be OK. I don’t think we’ve got any more energy shocks because of the Ukraine war. Yes, there are pipelines still flowing into Europe itself but, for me, I think the bigger risk is grain and if the Ukrainian offensive, which will most likely be down towards the Sea of Azov coast, around Mariupol and those ports. I think if they were successful the grain and fertiliser exports will be severely constrained. 

At the moment, China is receiving 4.5 million tons of that grain. It’s not actually going to the countries that dearly need it, like the Egyptians and others. So, I think that flow of grain and fertiliser will be key to this, but Putin certainly has it in his arsenal to restrict that if the Ukrainians are successful.

HP: Andrew, let’s try and think a little bit forward from where we are today. Where does the conflict go from here? What endgame scenarios do you envisage playing out?

AM: So, I think there are a number of issues. The Russians are conducting their offensive, their counter-offensive, at the moment. I think depending on the success of that will determine what happens. If the Russians actually take those four provinces back, they would be in a position, or Putin would be in a position, to declare victory to his local population. But it’s probably unlikely. They don’t have the reserves, they don’t have the ability to conduct manoeuvre warfare successfully and they’re going back to old Soviet tactics.

So then, so what? You’ve got the Ukrainian offensive when they get the Western equipment and the trained tank crews. If they’re successful and start pushing southwards towards the coast, then Putin will be in a serious dilemma about what to do. But I think both sides only have one shot at this. They only have the equipment and the ammunition, at the moment, to do one major offensive. If either side fails to achieve its goals I think the war will become quite static within the second half of the year, potentially while the West is still starting to supply western equipment for the long term.

So, maybe the end result might be probably more likely that the Ukrainians take more land back. Whether they get to the Sea of Azov coast is up for debate, but I think markets will probably stabilise towards the end of the year as we see, not a solution but at least a steady state in the war itself.

HP: OK. Finally, please could you share your thoughts on what the longer-term ramifications for international relations are likely to be? What does the future of global order look like?

AM: Yeah, I think this actually has much more to do with China than anything else, and how the US turn their attentions towards China, potentially after the Russia-Ukraine war stabilises or finishes, hopefully. So, actually, the global order, you will have a resurgent China, depending on how they go on with negotiating any peace, the economy booming, you’ve got the middle countries, so Saudi, Iran, the oil-producing countries in the Middle East, who are sitting on the fence at the moment between the US and China, and we put India to one side as a non-aligned country, in inverted commas. 

And then you have the US and Europe, who aren’t as aligned on China as they are on Russia. The Inflation Reduction Act has caused problems. There are some trade disputes in the wings. So, I think we’re just going to have to live with the next decade of very multipolar, destabilised world. I think maybe the big issue will be the fight over commodities and the critical raw materials needed for the transition to renewable energy.

HP: Well, thank you, Andrew, for sharing your insights today. It’s clearly been a devastating year for the people of Ukraine. We do, of course, continue to hope for a swift and peaceful resolution.

Let’s move on to the week ahead where the focus in the US will be on the durable goods numbers which are out on Monday. These figures reflect new orders for long-lasting manufactured goods. We forecast a 4.5% month-on-month drop in orders in January, with the decline led by transportation orders. Excluding those, we believe durable goods orders declined 1.4% month-on-month. For capital goods orders, excluding non-defence aircraft, we forecast a decline of half of 1% month-on-month.

In Europe, we expect February’s flash inflation report to come through. We expect headline inflation to print at +0.6% month-on-month and 8.3% year-on-year, which would represent a 35-basis point reduction from January in that annual figure. 

The move lower in year-on-year inflation will mainly be driven by base effects. We forecast most components will continue to deliver a strong month-on-month print, reflecting still very persistent underlying price momentum, despite growing cost-side deflationary pressures starting to come through. We expect core inflation to largely remain sticky in February, coming in at 5.24% year-on-year.

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

(end of recording)