Inflation: critical coming months
Following a month of falling bond yields and a modest stock market recovery on the hope of a fall in interest rate rise expectations, markets are once again pausing for thought as we enter August.
With Bank of England raising interest rates by 0.5% to 1.75%, its biggest rate increase since 1995, markets are poised for a further chill in financial conditions. A deviation from the current trend of rising interest rates feels unlikely at this point, despite optimism in recent weeks. We do however acknowledge that a recession will give central bankers a reason to consider just how much demand destruction, through the tightening of financial conditions, will benefit the UK economy in the current situation. This should eventually push them into lowering rates again, which would be positive for risk assets.
The case for monetary policy tightening is driven by the risk that inflation, if left unchecked, could lead to a dangerous wage and price spiral that we have not seen since the 1970s. However, the inflationary pressures do not stem from internal demand excess, as has been the case over the last four decades, but from external factors over which monetary policy setters have no control. Rate hikes will not solve the increasingly urgent food supply challenges or remedy the shortage of natural gas.
The war in Ukraine, which has led to a significant reduction in gas supplies to Europe from Russia, coupled with under-investment in US shale supply in recent years, leads us to believe that the current demand/supply imbalance in gas is not likely to be resolved any time soon. In the UK, the current gas price cap is forecasted to rise by a further 70% in October. This impacts both UK business and consumers and will likely lead to a significant contraction in consumer confidence and spending. Businesses required to use energy for various purposes from industrial production to heating pubs and restaurants, will see a significant rise in costs and resultant profit margin deterioration. It feels somewhat unlikely that the current low level of unemployment will persist, with the UK forecasting further challenges over the coming winter. All in all, none of this is good for the economy or financial markets.
There is also the matter of a struggling global supply chain, exacerbated by the pressure of China’s zero-Covid tolerance policy and the war in Ukraine. Key shipping ports are no longer as constrained as they were, but the situation is not fully resolved in either geography and is still in a state of flux and impacting the rest of the globe.
With this in mind, our client portfolios are defensively positioned at present. We believe that this is the correct conservative approach in light of the deteriorating economic and monetary environment. The green shoots we continue to look out for include a change in tone from central bankers, a deterioration in inflation forecasts, energy price pressures to recede and, ultimately, conditions which would support a sustainable recovery in consumer confidence. None of these have occurred as of yet, but we are confident that they will, and we will be ready to react accordingly and deploy the current higher than average cash positions held across portfolios. The catalyst will be the first sign of reduction in the rate of increase in inflation rather than the actual peak.
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