Inflation slowing

European inflation data out this week follows the trend increasingly evident in the US over the past couple of months, allowing the markets’ inference that perhaps the worst of the accelerative momentum in consumer prices is now past. German inflation (CPI) slowed to 10.0% from 10.4% in October, while the headline rate in France was static at 6.2%. More broadly, the eurozone rate more-or-less mirrored the German experience: eurozone CPI fell from October’s 10.6% to 10.0%. Amid a welter of underlying price pressures pulling both ways (across the eurozone, for example food, tobacco and alcohol inflation continued to accelerate to 13.6% from 13.1%), it was the significant deceleration in energy costs from a 41.5% year-on-year increase in October to a mere 34.9% in November which held sway in the overall balance of momentum. Prices are still rising uncomfortably quickly but at least at a slower clip than before.   

Energy! A complex and fickle master 

The cost of energy, whether the base fuel or electricity, has bedevilled the global economy for more than 15 months, ever since Vladimir Putin began his calculated programme in August 2021 of weaponizing gas as a geopolitical prelude to the main act, his invasion of Ukraine in February. Manifesting itself in the ‘cost-of-living-crisis’, western governments of all political hues have been stressed with how best to deal with it, some making heavier weather than others (Mario Draghi’s technocrat government in Italy failing to the point of destruction in August, for example).

 

However, before we get too carried away that inflationary pressures are all over bar the shouting, it is worth considering what the driving forces are behind oil and gas prices, particularly the less predictable elements beyond the simple laws of supply and demand and the balancing figure of global inventories. Geopolitical pressures remain very much to the fore. The preamble to this is that so long as both Russia and Ukraine have the means of sustaining the ability to fight, the war in Ukraine with its commensurate sanctions and Russian countermeasures will continue for the foreseeable future. On which score Joe Biden’s support for President Zelensky was further called in to question this week when Biden said he would be willing to talk to Putin about how to end the conflict.  

Global oil: shot through with geopolitical sensitivities and sensibilities  

It is two months since OPEC+ (the 13 OPEC cartel countries which account for around a third of all global oil production, led by Saudi Arabia and including sanctioned Iran, and the ‘plus’ countries, the affiliated members including Russia, Kazakhstan, Mexico, Oman and Bahrain) cut production quotas by 2m barrels per day (roughly 2% of daily global consumption) to try and restore the price of Brent Crude above $100. That strategy has failed so far. The US, both the world’s biggest producer and consumer of oil, responded by releasing inventory from its Strategic Petroleum Reserve to curb domestic prices. Global consumption was already slowing thanks to the measurable slow-down in the global economy; last week we discussed western business confidence being in recessionary territory, joined this week with Chinese manufacturing Purchasing Managers’ Indices being below 50 for the second consecutive month, indicating the likelihood of a shrinking Chinese economy. Traders anticipated a glut of supply from December when the EU’s embargo against Russian oil is finally due to begin and Moscow has to find alternative buyers who are willing to ignore the western sanctions regime against Putin (principally, but not confined to, China and India). And so far, in Europe and the US (but bearing in mind it is still only the beginning of December), it has been a mild winter with no abnormal weather-related calls on oil inventories.

 

On the other hand, amid the civil unrest in China prompted by President Xi’s zero tolerance of Covid while the wretched virus refuses to obey instructions and behave itself, let alone to die, combined with his equally low tolerance for free speech and access to the global internet, speculators have been betting that eventually the political risk for Xi personally will cause him to relax the lockdown regime, allowing a semblance of ‘normal’ human social and economic activity to be restored in China. In a study this week, the investment bank Nomura estimated that currently 25% of Chinese industrial output is disrupted thanks to Covid restrictions; in context, China is 18% of global GDP and before the pandemic one third of every incremental point in global GDP growth was directly attributable to China; China is a significant net importer of oil and frequently the major swing factor in global consumption.

 

The US and Saudi are the top two oil producers globally. Politically, to say that diplomatic relations between them are frosty would be an understatement. And Iran hates both. Saudi Arabia remains of the opinion that Joe Biden has simply carried on the US Democrat position in the Middle East from where Barak Obama left off: to stabilise US relations with Iran to contain Tehran’s nuclear weapons programme at the unacceptable cost of undermining Saudi Arabia, notably as the cornerstone western ally in a frequently febrile and strategically sensitive region, one in which Iran and Saudi are in a long-running proxy war with each other in the Yemen; the cultural clash between the US and Saudi on ‘values’ and human rights only exacerbates a rocky relationship. The culmination is that in the context of the global economic conflict with Putin, Saudi has been minded so far not to cooperate with US requests to help moderate oil prices and indeed faced accusations in Washington that the OPEC+ decision in October to cut production actively aligned Saudi with Russia. 

Gas and the transfer of power: relations with strange and unlikely new bedfellows  

If oil markets are global and fungible, gas markets on the other hand tend to be more regional and directional (i.e. the majority of gas is piped directly from a hole in the ground to the point of consumption; oil is traded globally and the supply chain has many more moving parts including the need for significant intermediate refining capacity between extraction and consumption of the finished product). Russia has now all-but ceased piping gas directly to Europe. The 30% of supplies to Europe accounted for by Russia’s Gazprom have been largely replaced by shipments of liquid natural gas (LNG) from the US, Qatar and Libya, and in Germany the reopening of mothballed coal-fired power stations at some political cost to Olav Scholtz. European countries had successfully topped up LNG storage tanks to their maximum capacity before winter sets in and before the Russians finally and completely turn off the taps. However, at 157bn cubic metres, storage capacity is finite; depending on national consumption volumes, it may yet require interstate cooperation about rationing among EU members to eke out supplies to see the winter through in the event insufficient quantities can be shipped in the meantime. That is not merely an economic conundrum but a political one.  

Gas prices rising again  

A year ago, European gas prices were €90/MWh; they peaked in August at €338/MWh and as recently as November 11th had dropped back to €97/MWh; today, thanks to Russia still playing cat-and-mouse with the last direct link to western Europe (via Ukraine, through the ironically-named Brotherhood pipeline) and though still relatively mild the weather nevertheless getting colder, the past fortnight has seen the European wholesale price back up to €154/MWh. Critical to where the price goes from here is a Brussels plan to set a price cap at €275/MWh across Europe, clearly anticipating further upward pressure on energy prices over the coming months until the spring. Par for EU inter-government negotiations, that agreement has already been delayed amid members’ bickering; a final decision is due on December 16th.  

‘You need it, we have it; let’s talk turkey. On our terms’  

Energy has always conferred geopolitical leverage. The peak leverage for oil producers was in the 1970s and while it has remained significant, it has undoubtedly been on the wane since (consider the last two decades in which Brent has fluctuated between $20 per barrel and $120, and for most of a decade was consistently over $100 without causing a global inflationary crisis). But now, with a confluence of major global events concentrated in an intensely short period (and one of those agents, Putin, has been a deliberately malign influence), oil and now also gas are once more important factors both economically and geopolitically. We have discussed the oil tensions between the US and Saudi; it was interesting this week amid all the controversy of the World Cup and Qatar’s human rights record, that former Prime Minister Sir Tony Blair warned of the potential reaction from Qatar with gas supplies should it too regard itself as being ‘disrespected’: to modify the saying, a case of “beware biting the hand that heats you”.  

The heterogenous nature of inflation 

But bringing the discussion back to inflation: the reported rate is simply a comparative figure; a rolling time series of like-for-like prices measured against periods in the past. All other things being equal, if prices stabilise then mathematically over time the rate of inflation drops (and if prices are static, eventually that rate drops to zero, self-evidently). Looking at the future of inflation, not only the peak and at what rate it subsequently subsides, that is a calculation of many complex factors frequently pulling in opposite directions but at the root of all of which is the net sum of human behaviours measured in pound notes, dollars, yen, euros etc. Neat extrapolative models are incapable of predicting the fickle nature of humans not always to stick to the economic script, as we have illustrated above at the geopolitical level in energy (and this year it has taken economists a long time to join the dots about their understanding of the drivers of inflation).

 

Two things to bear in mind on inflation: first, different countries have different circumstances; contrast the US which is largely self-sufficient in energy and whose economy is only reliant to a relatively limited degree on international trade, with Europe where reliance on outside agencies for energy and a significant level of exports and imports generates a very different dynamic. Second, there are differences in labour markets; as we have said before, in the context of input costs, commodity prices are volatile and can go down as well as up; nominal wages tend not to go down, the pressure valve is the rate of unemployment and the extent of industrial unrest in pursuit of wage claims. Economists look at the wage component of inflation as to its likely duration and stickiness.  

Central banks: if not quite Father Christmas, at least a little less Scrooge  

As for investors, as we pointed out last week, the kites are flying high ahead of the policy meetings of the principal central banks in mid-December (the Federal Reserve on the 13/14th, the Bank of England and the European Central Bank both on the 15th). But jumping the gun, this week Federal Reserve Chairman Jay Powell effectively confirmed in a speech that December’s interest rate increase in the US will be limited to a half point, and he reaffirmed that the pace of future rate rises will be moderated but may persist for longer. From which markets took further pre-Christmas cheer. All other things being equal.

 

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