Investment Comment
12th August 2022
Are we there yet?
Good news at last on the inflation front. Analysts have been trying to call the top on inflation for the last few months and been disappointed as inflation data has surprised higher but at last that sequence has been interrupted. The headline US inflation number for July came in at 8.5%, lower than the 9.1% recorded in June and there is every reason to believe that the peak in inflation pressures has passed, at least in the US (sadly here in the UK inflation is forecast to keep rising for reasons we discuss below). The data published on Wednesday also showed that on a month-on-month basis, there was no increase in inflation in July compared with the 1.3 per cent monthly rise in June.
The figures added further fuel to a two-month recovery in equity markets, as traders bet the Federal Reserve might temper its aggressive interest rate rises aimed at subduing soaring prices. While Fed officials went out of the way to reiterate their commitment to taming inflation with interest rate rises, markets have a rosier perspective and as expectations of rate rises have eased, bond yields have fallen, and equities have rallied. Bond yields (which reflect to some extent future interest rate expectations) peaked in June and have since fallen back. Likewise, equities hit a low at a similar time and have since rallied strongly.
In the chart below we show the absolute level of the S&P 500, the main US equity index, compared to the 10-year US treasury yield (inverted to make the comparison clearer). From the start of the year to the middle of June equities fell as bond yields rose, as high inflation forced central banks to tighten policy and raise interest rates. Investors priced aggressive rate rises into their forecasts and more latterly raised concerns that this tightening would drive the economy into recession.
Equities have rallied since mid-June as bond yields have fallen
Source: Bloomberg
It is too early to know whether this pattern will hold as the year progresses and will be highly dependent on the path of inflation and whether the US can avoid recession (we fully expect the UK and Europe to fall into recession in coming quarters). If inflation continues to fall and economic growth holds up (“a soft landing” or “Goldilocks” scenario) equities may be poised for continued strong returns. However, if inflation proves sticky and central banks tighten policy more than expected and/or the US falls into recession this will provide a far more challenging backdrop for returns. We’ll examine these alternative scenarios in our forthcoming Investment Outlook.
Winter of discontent?
As the UK goes through another heatwave and we bemoan our lack of air conditioning it may seem a strange time to be considering the cost of heating our homes this winter but this week we were invited to do so. Cornwall Insight published their latest predictions for the energy cap (gas & electricity). As the chart shows the main component is the wholesale cost and this is driven by the extraordinary rise in the price of natural gas, which surged following the Russian invasion of Ukraine and more recently as Russia has sharply reduced supply to Europe. The UK is particularly exposed because most homes are heated by a gas fuelled boiler and it is also the largest contributor to electricity production (approx. 40% of supply). The report makes grim reading with prices predicted to rise into next year feeding into inflation and exacerbating the cost-of-living crisis. It is worth noting how little impact some of the mooted responses might have on prices. Cutting green levies/fuel duty (policy costs in the chart) is a marginal component of the price, as is profit (EBIT in the chart) with relatively little of the price rise feeding through into profit for the domestic energy companies. Only direct support from the government will be able to alleviate the impact on those struggling with the price rises
Default Tariff Price cap levels chart since 2018 and Cornwall Insight’s predictions for the next four quarterly cap periods
Source: Cornwall Insight
Ultimately prices will stay high until natural gas prices fall and in the short-term that is reliant on Russia being prepared to pump gas into Europe despite ongoing sanctions. With little inflation in the price of wool, it might be time to buy a woolly jumper.
Gareth Thomas
Head of Investment Management
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FP20220812001 EXP 12/10/2022