In 2022, the spectre of inflation has burst back in the consciousness of markets with a ferocity not seen since the 1970s. Several times this year it appeared as if price pressures were moderating, but they proved false dawns. Most recently, September’s US consumer price inflation (CPI) data saw the headline inflation rate fall very slightly, driven by falling oil prices – but more importantly, underlying core inflation increased, led by items such as rent, medical services and transportation services.
This evidence of price pressures having broadened far beyond base commodities, and thus harder to fight, will be deeply troubling for central banks across the world, and in response, they appear to be throwing the kitchen sink at the problem with higher base rates, balance sheet reductions, and hawkish rhetoric. The subsequent jump in yields – both nominal and real – has turned up the pressure on the real economy. Higher rates squeeze activity by making refinancing more expensive. Real estate and corporate investment alike are set to slow sharply. Recession now appears inevitable in most developed economies.
In the UK, the rate hikes have been less spectacular than in the US, but that belies a much more challenging policy backdrop. For one, rate hikes in the US are coming in the face of “demand-pull” inflation, but in the UK (and Europe), it’s of the “cost-push” variety, particularly linked to energy prices, more specifically the enormous increases in natural gas. In this environment, rate hikes will serve to weigh down already slow conditions, helping with inflation, but exacerbating the depth of a recession.
To make matters more complicated as well as more painful, higher US rates and yields given the relative economic health across the pond have led to surging demand for the dollar. Indeed, over the past three months, the US currency has experienced its biggest quarterly rise since the first quarter of 2015 and remains the strongest it has been in two decades. In effect, a surging US dollar is akin to the US exporting inflation around the world as global commodities are priced in US dollar terms, and those commodities become more expensive in currencies such as sterling, all else being equal.
Global equity markets, pricing in much of this scenario, ended the third quarter at a loss, the first time three consecutive quarters of losses have been posted since the aftermath of the global financial crisis more than a decade ago. However, it was in the normally staid worlds of bonds where the pain has been even more acute. In the year ending September, an index of UK government gilts (Bloomberg UK Gilt 7-10 Year Total Return) is down over 20% - one of its worst years ever. The majority of that loss occurred in the third quarter, particularly in a dramatic end.
In the waning days of September, the new UK Chancellor of the Exchequer waded into already muddy waters with a dramatic, expansionary shift in fiscal policy. To the degree government spending was in response to surging energy prices – the government announced an energy price freeze for most consumers and businesses – it was tolerated by markets. However, he also announced huge cuts to current and future taxes in an extraordinary policy moonshot meant to reverse years of productivity declines and moribund economic activity. Here the market backlash was immense and included a head spinning sell-off in both the British pound (sterling) and UK government bonds (gilts). The collective market’s view was unequivocal: such a large fiscal expansion – funded almost entirely by borrowing – will dangerously exacerbate already high inflation, the actual root problem of today’s real economy.
As we enter October and details are still to be published, the Chancellor has announced a few concessions to his stated policy, the BoE has had to step in to reassure market and try to stabilise sterling and the gilt markets. Time will tell if this is enough to calm markets.
Global equity markets, pricing in much of this scenario, ended the third quarter at a loss, the first time three consecutive quarters of losses have been posted since the aftermath of the global financial crisis more than a decade ago.
In accordance with the regulations in force, we inform the reader that this document is qualified as a promotional document. CA25/S1/21. Unless specified, all figures and statistics in this report are from Bloomberg and Macrobond on 03/10/2022.
