This past Friday, copper soared over 7.5% and even oil had its own little party up 5%.
So what happened?
Well, you wouldn't be faulted for thinking there were some rumblings of the long awaited
Fed pivot, especially in light of the substantial weakness in the US dollar.
But really it had everything to do with something else, something far from U.S. soil in fact;
unconfirmed rumours that China is warming up to the idea of easing its Covid-Zero policies.
Was Friday the warning shot of a renewed bout of commodity strength.
And if so, what might that mean for the Fed's battle with inflation?
That's this week's Big Conversation.
The reason Friday's action should be on all of our radars is really quite simple.
Over the past several months, commodities have eased off the torrid pace they began
the year with.
In many people's opinion.
It's been the ongoing monetary tightening starting to play its part in the Fed's objective
of softening economic demand.
And yes, the pullback in commodity prices has helped to ease some of the inflationary
pressures the world was facing earlier in 2022.
But if China's potential reopening is as bullish for commodities as the market has suggested
over the past few days, then there's a very real risk that the infamous "Fed Pivot" has
been delayed.
Let's be crystal clear, though.
The rumours that had the markets so excited on Friday were just that, rumours.
In fact, Chinese health officials held a press conference this past weekend to address their
targeted COVID prevention policies.
According to one National Health Commission official, China's practise has worked.
They've apparently proven that their pandemic prevention and control strategy is the correct
one, and as such, their measures are proven to be the most economical and effective.
So much for ending those COVID lockdowns...
To be fair, buying too much into unconfirmed social media posts carries its own risk.
But, the constant back and forth on this topic is enough to make anyone's head spin.
Now, come Monday morning, various news outlets reported that China was indeed weighing a
gradual exit from its Zero-Covid policy.
They stated that it expects to proceed with caution and without a fixed time frame.
But instead of racking our brains about whether or not China will actually abandon their current
COVID strategy, it's helpful to simply think through the ramifications so we can be better
positioned for the ultimate outcome.
So let's go back to the commodity complex.
There are some beliefs that China's Zero-Covid policy has contributed to the softening in
oil prices as a result of reduced Chinese demand.
Same could be said for copper.
Well, that and the significant deleveraging that we've seen play out through stress in
major developers such as Evergrande over the past year.
But what if both of those forces are about to reverse course?
According to recent data released by the People's Bank of China, the broad money supply - as
measured by M2 - climbed 12.1% on a year-over-year basis as of the end of September.
So, yes, Chinese policymakers appear to be back with fiscal supports, which should lend
support to industrial commodities.
On the other side of that coin, though, there are deflationary aspects to consider as well.
For starters, easing measures at a time when the rest of the world is still engaged in
monetary tightening, could bring about weakness in the Chinese yuan.
A weaker yuan is broadly thought to be deflationary
for the rest of the world, in the sense that
other countries are now importing cheaper goods.
And then there's these supply chain issues, which are still all too real, as evidenced
by Apple's recent announcements that COVID restrictions in China has led to significantly
reduced capacity and thus slowing shipments of its iPhone.
If you remember, reduced capacity across manufacturers
in ports operates, as was largely pointed
out as the root cause for major shipping bottlenecks,
which ultimately translated into a surge in
shipping costs in 2021.
Again, if we are to believe that China will slowly emerge from drastic lockdown measures,
that's another feather in the cap of those hoping for smoother operations within the
global shipping complex.
So basically, which one will it be?
Will China's potential reopening create additional inflationary pressures?
Or could the deflationary aspects be enough to offset those concerns?
Well, that's the looming question that will require further investigation.
The Fed has already performed a significant amount of monetary tightening.
And as Jerome Powell always reminds us, their measures act with long and variable lags.
The real answer is likely to be far more nuanced than just one overarching implication.
And take, for example, the shipping sector:
If U.S. demand is slowing, while supply-chain bottlenecks are set to ease with China's exit
from Zero-Covid, then we could be looking at a difficult environment for shipping stocks,
which have enjoyed an enormous boom over the past two years.
On the other hand, global materials stocks could be facing another demand surge due to
China's increased fiscal support.
All in all, if you are in the firm camp that the Fed pivots soon, then this episode should
give you reason to pause and think.
The recent developments in China, or should I say rumours of developments could muddy
the picture for an already uncertain outlook.
While the deflationary aspects might be enough to offset the renewed inflationary pressures,
the Fed may not need to do a whole lot more.
But maybe it's an argument that rates will simply need to stay higher for longer.
And if rates do indeed stay higher for long.
Well, investors might actually need to dust off those old fundamental analysis textbooks
after all.
Hello, and welcome to The Chatter. Now, I know a lot of US investors have been keeping an eye on
the UK more recently, given the fast-changing government and big swings in Cable. So,
to discuss more about what changing governments could mean, here, in the US,
given the midterms. And what the recent rise in commodity prices could mean for UK and Europe,
I sat down with Brian Hilliard, Chief UK Economist at Société Générale.
Dr Brian Hilliard, welcome to The Chatter.
Thank you very much. I'm pleased to be here.
So, Brian, we have been talking quite a bit this week about what happened on Friday,
which was really a big move up in a lot of commodities prices. It was
fuelled by rumours of China, essentially, relaxing their COVID policies and, perhaps,
seeing Chinese demand back once again. The reasons we found it such an interesting topic was because
it may reignite the inflation story once again. Give another leg-up to the inflation story.
Now, in the US, where I am, it feels like Jerome Powell has a little bit more room to keep hiking,
given the labour market is pretty tight. But if you could just give us a little
synopsis of what the inflation story is now in the UK. What you think is going through
the minds of the BOE, and your outlook for inflation within the UK right now.
Well, the UK inflation environment is completely idiosyncratic. The reason for
that is that we have a utilities regulator that until recently, has been setting a price cap,
based on energy price futures at the highest marginal cost producer, which is gas. That
meant that we’ve already seen increases of 54% in April. The next one, if it had gone through
in October... Well, the one that did go through was 25%, even with some kind of price guarantee.
Unregulated, it would have gone, maybe, 80% or higher. And then,
in April next year would go up again. So, it’s very much tied in with the
specific lags that the regulator imposes by resetting this price cap every six months.
The politics are very messy because of the brief reign of Liz Truss as Prime Minister. She put in
place an energy price guarantee, which would’ve lasted two years, and that would have meant,
pretty certainly, that the peak in inflation was a little below 11%, now. Rishi Sunak has taken over,
he’s pared back that energy price guarantee to six months, and then is going to have a review.
I think that review will end up, maybe, rolling over the price guarantee for another six months,
but no longer, and targeting it in terms of benefit payments to those who are most needy.
So that means you will see more of a plateau, I think, in inflation, rather than a rapid fall. But
it still could be 6%, 7% by the end of next year, and then coming down more rapidly after that.
In terms of monetary policy, things are getting very, very complicated. The Bank of England,
clearly, is very worried about domestically generated inflation. It accepts that, maybe,
70%, 80% of inflation is outside their control, through commodity prices. So
that point you're making about China has a great bearing on that, as well.
But they're trying to control inflation expectations, which were complicated by these
strange energy effects, but they condition their forecasts on what the money market
believes interest rates are going to go to. I’ll explain that carefully because it is quite messy.
We had in the latest update of the forecast last week,
conditioned on market profile that rates would peak, maybe, at 5.25%.
Now, the Bank of England went out of its way to say well, no, no, we’ve got to use
some kind of conditioning assumption, but we don't think rates are going to get anywhere
near that. But if we can be even more specific, they've produced two sets of forecasts. One,
based on that market rate profile, and that takes inflation down to zero in three years’ time. Even
on unchanged rates of 3%, it takes inflation to 0.8, with a massive output gap opening up.
So, the only question one could ask is why are you raising rates from here? Why are you giving that
signal? As, indeed, they still are. The answer is that they have gotten themselves into a bit of a
mess. I think what it tells us, at the very least, is that in conjunction with this forecast of an
extended recession, which would be eight quarters on their market profile assumption, that there's
very little need to raise rates much further. My forecast is that they go up, maybe, another
1.5% to 4.5%, but the risk is balanced, at best. Possibly, more to the downside from that peak now.
If I may ask you, Brian, about a month ago, or however long it was, when previous Prime
Minister Liz Truss, still amazing to say that, came out with her economic plan. The
sterling started tumbling, and the BoE didn't decide to do an emergency rate hike. Instead,
they went and bought gilts. Was that a sign to you, at all, that the Band of England
is less interested in raising rates? And, perhaps, more interested in seeing if a
recession will naturally bring down inflation and, therefore, there's no real need to raise rates?
I think it’s not quite that straightforward. I think that we should interpret that purchase
of gilts as QE, so it is a temporary easing of policy. But it was addressing a financial
stability risk when the pension funds got themselves in a bit of a mess with their
LDI strategies. But since then, they've actually set up this active gilt sale,
so quantitative tightening. So, they are on a tightening path, still, but I think the financial
instability that they stepped in to correct, does, at least, point to a very cautious approach to
any more tightening. And yes, they do know a recession is coming. They think it’s going to
be pretty extended, so I think we can't believe that they're going to be acting aggressively.
I'm guessing Mr Sunak is going to have to find a way of paying for these energy-relief packages.
Where do you see an increase in tax coming from?
Well, he’s going to do it in a... Well, he’s done it already, which is stealth increase,
by not increasing nominal income tax allowances. When we look at the previous set of forecasts on
public finances from the official fiscal watchdog, we were reaching tax-to-GDP ratios that were 40-,
50-year highs. Because of that stealth increase through income tax allowances being frozen.
They will do more of that. They will extend those income taxes, those allowances, in nominal terms,
at the same level for more years. They've also said that they're not going to go ahead
with this planned cut in income tax from 20% to 19%, and that was when Rishi Sunak was,
previously, Chancellor. So, they're going to do that. I think windfall taxes of some
kind will be extended. There is a debate about extending the energy windfall taxes and, maybe,
changing the taxation regime of banks a little bit. So those are the ways they’ll do that.
The other side of the coin, of course, is spending cuts. Let’s say, roughly, they going to do 50/50
tax increases, spending cuts, spending cuts are very, very difficult to do. We’ve had an extended
period of austerity in the Cameron-Osborne years. And that's really cut down to the bone, especially
when you consider that the UK government sets its spending plans in nominal terms. Inflation has
meant that there's very deep, real cuts. So, they can't do that over the existing planning horizon.
They've got to load any fresh spending cuts into the back years of the forecast, maybe out to 25,
26, 27, which, guess what, comes after an election. But the public aren't fooled. I
think an important political point to make is that although the new Sunak administration has allowed
a return to stability, it doesn't get a return to popularity. The Labour Opposition Party is
well ahead in the polls. So, I think whilst one is looking very short-term at policy stories,
one has to have one eye on two years ahead to what the Labour Party may want to do.
I want to ask you about housing, if I can, Brian.
I'm wondering if housing is a more sensitive issue in the UK than it is in the US. I think I'm right
in saying a higher percentage of mortgages in the UK are on floating rate versus, over here,
in the US. How much does that factor into what the BoE decides to do next?
I don't know the precise numbers, comparing the two countries. But
we’ve seen, already, that fixed-rate mortgages, which are an increasingly
important part in the UK, people have been trying to reset those fixed-rate mortgages.
They've found because of the massive increase in gilt yields, partly because of the global trend,
but also, because of what you might call the Truss risk premium, the resetting of those
fixed-rate mortgages is at much, much higher levels. What that’s going to do, I think,
is push a housing market that was already overdue for a correction into a downturn.
We’ve seen two of the most closely watched house price indices, the Halifax, and the Nationwide,
show pretty sudden monthly downturns in the latest data. So, the housing market’s going to weaken.
Do you make any forecast about what kind of weakening we could see?
No, I don’t give a specific number, but I think that the house price inflation,
because of some anomalies, peaked at 15%. It’s going to come down well into single figures,
I'm sure. I think the housing transactions, housing volumes are more the issue. So,
the housing market is going to slow down materially, I think that's the big point.
I wanted to ask you, I know there’ll be a lot of people in the US watching this,
do you have a view on Cable? Obviously, we’ve had some pretty material moves over
the past couple of months. Do you have an outlook for Cable? I guess there’ll
be people wondering whether they should be spending Christmas in New York or London.
Well, I would defer to our FX strategies, but the basic point is that we’ve become obsessed with
expressing the confidence of financial markets in the UK by looking at sterling
against Cable. The Cable, in particular. But it’s more a dollar phenomenon than it is a UK
Sterling phenomenon. Dollar is tremendously strong against everybody. Sterling has weakened on that.
We should have a period of stability now,
but it’s about relative rate expectations. If people are looking for a peak forming Fed rates,
maybe a little earlier than otherwise would have been the case, and the UK is still raising
rates. That's going to provide some sort of stability. Maybe a modest upside to Cable.
Brian, finally, just to ask you about employment. How do you see
the unemployment level looking over the next, say, 6 to 12 months in the UK?
I think it’s going to rise steadily, but gradually.
We have a strange situation here, where we’ve had the unemployment rate at multi-decade lows,
even though we know that employment growth is weakening. What is happening is that the
level of inactivity is rising, and that's because there are more long-term sick.
Partly because they didn't get treated properly during the pandemic, for obvious
lack of contact reasons, if you like. And also, long COVID, itself. And also, people
in the 55-plus age group moving into retirement. Maybe pandemic lockdown was a dry run for it,
if you like. So, all those things are presenting a slightly strange picture in the unemployment rate,
but I think that the rate is going to rise. I think employment is,
certainly, weakening. We’ve seen the top in the employment growth,
and it’s on its way down, and we may actually start to see some falls in employment.
It does feel like employment data has been somewhat skewed over the
last two years, and it’s actually quite difficult to get an accurate reading,
whether it’s over here in the US, or in the UK.
Yes, indeed. The complicating factor in the UK is we have two sets of data. One,
which is what you might call the definitive labour force survey data, which
covers a three-month period, but is not very timely. And then, a new set of data,
which is payroll data. That, sometimes, paints a slightly better picture, a stronger picture.
The way it’s growing that circle is to observe that the labour force survey includes
the self-employed. Payroll employment has got back to pre-pandemic levels,
but self-employment has not. I think with the recession probably having started
already. Self-employment has peaked already. So that’s going to take the
shine off the numbers. It’s a very sensitive indicator to weakness in general activity.
Well, Dr Brian Hilliard, Chief UK Economist at SocGen, I want to say
thank you so much for your time. I know you're a busy man. Once again, thanks for joining us.
Thank you very much, it’s been a pleasure.