Below is an analysis by Mark Dowding, CIO of BlueBay, for the last week on the markets.
When they weren’t sitting daydreaming about Netflix’s surreal Squid Game, market participants focused on the short end of the rate curves this week. For years, the “red light” to rate hikes has effectively stalled short-term yields, but this week saw the market move to price a UK rate hike – in just one day. This came after comments from BoE Governor Bailey on Sunday, when he remarked that while monetary policy cannot resolve supply-side bottlenecks, central banks still need to react.
All of this has prompted the market to question the future path of monetary policy and raised concerns over potential 1970s-style stagflation, especially in the UK, where supply shortages and continuing uncertainties over Brexit weigh on growth prospects.
UK inflation slowed slightly and was below expectations this week, but this decline was well signaled as being due to base effects, and we expect inflation to rise over 6% in the months to come.. However, it is becoming increasingly clear that the country is not the only economy that could see inflation above 6% in the months to come.
Both data and market prices are approaching our long-held expectations that the supply shock could have lasting repercussions on global supply chains.
With the market already addressing shortages in the energy sector, we are now seeing problems in other industries such as automotive, where demand for magnesium is currently under pressure, with far-reaching consequences for manufacturing.
As prices rise, sentiment indicators have paused a bit recently, but the consumer continues to spend, as evidenced by US retail sales which last Friday showed 12% year-on-year growth and those of China, which exceeded expectations with a rate of 16.4% y / y. This indicates that, for now, companies have the power to pass higher prices to consumers, and therefore those prices are more likely to manifest in inflation, rather than impacting corporate margins.
Indeed, the earnings season has started well, pushing many equity indices to new highs and offering support for risky assets across the board. After starting the month amidst the storm of Chinese real estate and the US debt ceiling, equities now seem oblivious to negative news, such as the spike in Covid cases which seems to lead to new restrictions in some countries.
Emerging markets
Emerging markets, on the other hand, continue to trade on the defensive, with several idiosyncratic issues in focus. In Turkey, the central bank cut repo rates by 200 basis points to 16%, despite inflation being close to 20% and there is a risk that further currency weakness will push it even higher. This followed the Erdogan’s decision last week to fire several central bankers who weren’t aligned with his unorthodox monetary policy of cutting rates when inflation rises.
Meanwhile, in Brazil, Bolsonaro seems to have managed to avoid the accusation of murder and genocide, but most likely the results of the Congressional investigation will not help his popularity as next year’s elections approach and there will continue to be doubts as to whether fiscal austerity is the right policy for an economy whose growth is expected to be among the worst in the G20 countries in 2022.
Also growth forecasts for China remain weak, even if in Evergrande’s “tug-of-war” between domestic and foreign investors it seems there were two winners, with coupons eventually paid. Despite the negative impact of managing the credit slowdown in China, the positive factors represented by solid exports and demand in a very slow economic reopening phase will likely support the outlook looking ahead, leaving the country in a less leveraged position. , without falling into the trap of global liquidity, from which many other developed countries often struggle to escape.
Looking elsewhere, some countries are playing their cards right. The bottlenecks in commodity supply come not only from current disruptions in transportation, but also from several years of under-investment, while the price of oil was below $ 60, and the additional costs associated with driving a global economy more green. This is supporting the current current account dynamics of commodity exporters.
The terms of trade have also improved significantly in Australia, where the collapse in the price of iron and an uncertain growth outlook for China cast doubts on the growth forecasts for exports. However, the prices of coal and natural gas more than offset the reduction in the price of iron. We expect this dynamic to continue and some countries are taking advantage of strong external demand to move away from low interest rate policies.
We have already seen Norway and New Zealand abandon them and we expect these countries, in our baseline scenario, to continue to raise rates. The trade balance data in Norway last Friday rose to a 40-year high. New Zealand inflation, released this week, is at 4.9% qoq, up 0.7% from forecast and we expect it to rise to around 6% in Q4 2021 and Q1 2022 .
Europe
Returning to our theme on the Squid Game series, the ‘sick old man’, i.e. Europe, will show its teeth next week when the ECB meets. It seems likely that Wednesday’s news of Jens Weidmann’s resignation could further unify the Eurotower. Potential successors such as Jörg Asmussen, former Deputy Minister of Finance of the Social Democratic Party, Claudia M. Buch or Isabel Schnabel all seem more centrist and integration-oriented.
Messages from Lane and Villeroy this week have led us to believe that the ECB will reject current prices in markets that have ambitiously ruled out negative cash rates within the next two years.
Credit
Credit markets continue to recover after the recent period of modest spread widening, but are showing no signs of trading outside their relatively narrow range. Credit Default Swap (CDS) indices saw slightly larger spread movements. This appears to be where many investors have implemented short-term hedges, which have subsequently been removed, thus bringing levels back to where we were in early October.
As highlighted, the quarterly season is gaining momentum and generally beating expectations, which is allaying fears of downside surprises on the supply chain front this quarter. This also means that primary market activity has been subdued due to business disruptions, which in turn has made the credit market calmer.
Looking forward
We are still at the beginning of the market squid game, and it remains to be seen who will survive at higher rates in the future. A “green light” for rate hikes could be painful enough for some sectors of the economy, and not all governments will have the skills to stay on course.
We continue to prefer countries with a solid fundamental context and orthodox policies, but central banks and governments must be very careful about how they adapt to the next cycle. Some monetary tightening, such as in the UK, may be too premature and the market will be quick to punish mistakes.
A difficult game awaits us, let’s hope it’s not to the death!