As we said a couple of weeks ago, the principal investment battlefield currently is the bond markets. With yields still jumping up and down like demented fleas (and each time prices moving in the opposite direction), opinions are sharply divided among investors as to what is happening. 

US inflation hits 9.1%. Does it matter?  

The one incontrovertible fact is that this week’s US headline year-on-year inflation figure for June came in at 9.1%, well ahead of the consensus 8.8% estimate. A full half percentage point higher, it compared unfavourably with May’s 8.6% (which again went against market forecasts). Indeed 9.1% is the highest rate recorded in any 12-month period since November 1981. What divides opinion is whether it matters.

 

Those who say it does point to the fact that in nominal terms it is a horror: absolutely not part of the Federal Reserve (Fed) or government script, that at 4.5 times the central bank’s target inflation rate and in persistently outstripping analysts’ forecasts and confounding the Fed’s hopes, the problem is worse and more persistent than imagined (rather than the economists were wrong, perish the thought!). Those who take the opposite view apply the ‘rearward-looking’ argument, that the data is historic and already out of date; the world has moved on and in the critical intervening weeks the majority of global commodity prices including wheat and crude oil have and are easing rapidly; with a recession looming the inflationary worst is over.

 

Both opinions are valid. But, as ever, nothing is straightforward here. With Brent crude oil dipping below $100 per barrel this week for the first time since early April, it reflects a number of developing factors: the global economy is demonstrably slowing, and with it demand for oil; in China, the resurgence of Covid, and in particular a new variant of Omicron, is yet again seeing the reimposition of local and regional lock-downs (which as recently as 10 days ago were being gradually relaxed) raising the possibility of more economic dislocation and slower growth in the economy both domestically and internationally; more tenuously given his deluded pursuit of the Iranians to reignite the nuclear containment treaty, that President Biden is visiting the Gulf, and Saudi in particular trying to make diplomatic amends and to restore fragile relations with the Kingdom in the hope that Saudi and other OPEC members will open the production taps to help alleviate the energy price pressure (to which the obvious riposte is that at nearly $40 off its March peak, the price seems to be relieving its own pressure without any additional supply being required). 

Markets and the Fed pulling in opposite directions (again). Yield curve inversion a reality  

Much of what is being fought over in bond markets is the inevitable debate over what the US central bank does next. The Fed’s recent rhetoric has been unrelentingly aggressive: it will do ‘whatever is necessary’ to help contain inflation and to relieve pressure on hard-pressed household budgets. Not content with quarter, half and even three-quarter point rises at one sitting, it is not being entirely discounted that the next policy meeting on 26/27 July might see a no-holds barred, full-point increase. For once, it would be accurate to describe that as a ‘hike’!

 

If the Fed as recently as a couple of months ago was optimistic that it would be able to engineer a soft landing for the US economy, markets are less than convinced. Supporting their arguments are other economic data: US retail sales growth has been declining consistently since January, turning negative in May; the number of jobless is starting to creep up after the strong post-pandemic recovery; in the manufacturing sector, the purchasing managers’ index (PMI) for the outlook for new orders fell below 50 to 49.2 in June from 55.1 in May, the lowest number since the beginning of the pandemic (warning: PMIs are not hard, recorded data—they are a snapshot of business leaders’ confidence of the future as measured through the responses to set questionnaires; as such the results are ephemeral but they do give a sense of a shop-floor outlook rather than what has already happened in fact; when the index is above 50, the implication is of sufficient confidence to see a growing economy; when below 50, it shows declining confidence and implying the risk of falling GDP).

 

Finally, the bond markets themselves, as seen through the yield curve: this week found the US 5-Year government bond yield (3.02%) joined by the 2-Year yield (3.09%) both exceeding that of the 10 Year (2.92%); indeed the 2 Year yield currently exceeds the 30-Year’s 3.08%. That’s proper inversion of what should be an upward-sloping curve. As we have said before, an inverted yield curve is not itself a hard predictor of an inevitable recession, but it points to the risks of one taking place if short-term financing costs are pushed too high and too quickly, causing financial stress as the system labours under the financial burden of supporting its own debt. 

Rock-bottom Bailey  

US investors are not only trying to steer the Fed away from overcooking interest rates and running the risk of crashing the economy in the process, but they are now also trying to lead the Fed towards reducing rates again next year. The position in the UK is different. Here, Andrew Bailey, Governor of the Bank of England, is ahead of the game: he said this week that it is his expectation that base rates will return to ‘rock bottom again’ when the war in Ukraine is resolved, at which time he foresees long-term secular deflationary pressures re-exerting themselves, forcing inflation down to the Bank’s mandated target rate of 2%. He could be waiting for Godot as far as the war is concerned. He is in good company with his peers but given how wrong he has been in virtually every one of his indications of tautological ‘forward guidance’ since coming into office, such sentiments need to be taken with a tablespoon of salt: call them aspirations rather than a hard forecast of future policy. As it is, he has opened up a can of worms about the wisdom of perpetual zero interest rate policy, but let’s cross that bridge when we get to it. 

Putin calling the shots; Draghi his first demonstrable political trophy in World War Three 

All of which leads neatly to the immediate joker in the pack, Vladimir Putin (China gives cause for concern too, but for another day). In his prosecution of economic warfare with the West, will he shut off all gas and oil supplies to the EU ahead of and for the duration of the winter? He makes no secret of his aims, as repeated in a broadcast last week: the dislocation of western society and the fomenting of civil unrest through rising populism brought about by his willingness to pursue ‘catastrophic measures in the energy market’, particularly if the West applies any further sanctions against Russia (no doubt, as well as economic measures, he will be continuing with his asymmetric tactics of undermining democratic processes and attacking institutions and infrastructure using cyber warfare). French and German government ministers rate the likelihood of an all-out energy embargo applied by the Kremlin as being a probability rather than a possibility.
His plan is working: disagreement about the cost-of-living crisis has led to the virtual collapse of the Italian coalition government this week, prompting technocrat Prime Minister Draghi (a former President of the ECB, no less) to offer to resign; Putin will be quietly chuffed given Draghi was one of President Zelensky’s sponsors for Ukraine’s proposed accession to the EU.

 

With Boris having been Zelensky’s chief friend in NATO and much the most effective global statesman putting vim behind ejecting Putin from Ukraine and now defenestrated by his own Westminster MPs, in the propaganda war Putin will be claiming two significant opponents’ scalps in one week. 

Pat economic theory only goes so far when faced with uncontrollable factors  

Here is the rub. Markets are inherently forward looking. Reported data, such as the June US inflation report, is useful as both a factual record and a reference point of reality. But it is an appreciation of future conditions which determines current asset prices and the assumption of the discount rate used in their pricing. The discount rate applied is itself a reflection of future interest rate estimates with an additional fudge factor for the investor’s appetite for risk, whether that be greater or lesser. Naturally, investors tend to make comparisons with the past as a form of anchor point and reassurance as to the validity of their prognosis of what might yet be to come, and how to deal with it. You can see it happening today: references to the 1974 oil price shock; comparisons with the hyper-inflation and economic stagnation of the 1970s; political dislocation and industrial action. But the difference this time is the significant exogenous shocks, especially Putin’s Ukrainian offensive: in particular because the knock-on global economic effects are not merely incidental collateral damage, as happened in 1974, when Saudi-led OPEC applied oil sanctions against countries which had sided with Israel in the Yom Kippur war. Now, through the calculated weaponization of energy and food, Putin is actively looking to bring down the West through insidious and pernicious means. How far he is prepared to go to achieve it remains to be seen, as does the extent to which the western democracies can hold the line sufficient to defeat him. It is impossible to get inside his head, but the corollary is that rationalising his actions through one’s own lens and applying pat text-book economic theory to today’s conditions runs the distinct possibility of reaching the wrong answer.

 

However improbable and irrational it might sound, it is more than possible that Putin will indeed go all-out in cutting off western European energy sources. Estimates vary widely about the effect, but for Germany alone, the annualised hit to GDP ranges from 4% to as high as 12%. Italy too, the EU’s second biggest manufacturing economy and also heavily reliant on Russian gas and now mired in political instability, would also be significantly affected (and with 150% debt to GDP, its finances are distinctly wobbly compared with Germany’s).

 

FX paints the picture: relentless dollar strength and Euro/dollar parity  

If the bond markets are at sixes-and-sevens about the European outlook (the ‘inflationistas’ and those concerned about future uncertainty pushing for higher yields and interest rates versus those who see relentless economic pressure and the need for retaining loose monetary policy, inflation will sort itself out anyway), it is the currency markets which are acting as less of a battlefield and more as a reliable overarching barometer of sentiment.

 

The US is far from immune from global economic downdraughts but being a relatively insular economy in which over 75% of its GDP derives from domestic activity rather than imports and exports, and given its near self-reliance on oil, it is relatively protected. The dollar remains the principal global reserve currency, and the Fed is raising interest rates. Investors have therefore been flocking to dollars for protection. In what has effectively been a one-way trade, the dollar has been appreciating remorselessly for several months, the index against a broad basket of currencies rising 7 points from 115 to 122 year-to-date. The corollary of that is weaker exchange rates on the other side of the trade. As the sterling/dollar rate falls to $1.18 having begun the year at $1.35, there is talk of a ‘sterling crisis’ as if sterling is universally sinking. In fact, against the euro, at €1.18 to the pound, our exchange rate with the eurozone is identical to the beginning of the year. As we write today, on the other hand, and reflecting simultaneously the relative confidence in the dollar and the US economy and the bleak outlook for Europe thanks to a major war on its doorstep and its entangled and compromised relations with Moscow, the euro has just reached parity with the dollar, one-for-one, having dropped 13% from 1st January. Arguably, if the bond markets are a bundle of nerves and confusion and mixed messages, the currency markets are a better pointer of the economic state of the world as God sees it.

 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions. 

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