Whilst there are calls for US
inflation to peak this quarter,
inflation is spreading further
afield and becoming embedded in
other goods, especially food
products, which will have far more
impact on consumer sentiment than
the durable goods which was soaring
last year.
And a broadening out of inflation,
whilst it may not necessarily drive
headline inflation higher, the
impact on consumers could
spur yet more action from a greater
number of central banks, putting
even more pressure on global
financial conditions.
And that's what we're going to look
at today in The Big Conversation.
Over much of the last year,
inflation was primarily about
surging input prices for producers,
leading to some eye-wateringlevels
of producer price inflation.
Whilst PPI is generally much more
volatile than CPI, some of these
moves were still extraordinary.
For consumers in the US it was
more about the rise of durable and
consumer goods with lumber and
second-handcar prices leading the
way and helping push CPI
to a 40-yearrecord.
And Europe was severely impacted by
issues across the energy sector, and
that was before the war in
Ukraine, which then saw energy
prices take yet another leg
higher. And in the US, gasoline
prices have already topped $4.50,
with many predicting $8 or
more, as well as potential
rationing. The recent breakout of a
consolidation pattern in crude oil
is another ominous sign.
Brent has recently touched its
highest level since the margin shock
in March. Today's prices are being
driven more by fundamentals than
they were a couple of months ago.
Although month end expiry did play a
part for Brent, but the real
headache for central banks across
the world is the rise in food
prices.
In many regions, food prices are
only a small percentage of the
shopping basket.
But it's still a painful reminder of
choices that many families will need
to make. And in other less affluent
regions, there are no choices when
food prices surge.
There are many countries who have
historically subsidised essentials
like food and energy, but that's
not an open-endedgame.
Eventually, subsidies become a drain
on government finances, which can
negatively impact a country's
currency and increase the
inflationary shock on government
balance sheets, or the subsidies
are capped and the higher costs
eventually are passed on.
So whilst the potential peak in CPI
may ease some of the short-term
pressures on US policymakers,
there is still a potential for
inflation expectations to become
unanchored.
Often policymakers will respond to
the market price of inflation
rather than the actual level of spot
inflation.
Though both will be taken into
consideration.
The US five-yearinflation rate in
five years time hit 2.8%
on an intraday basis on Tuesday,
very close to the recent highs
before then closing lower on the
day. Inflation expectations often
follow the gyrations in the oil
price, so if crude moves through the
highs, then inflation expectations
are likely to follow.
And rather than pulling back from
the current rate-hikingtrajectory,
the Fed may therefore need to act
decisively to maintain credibility.
The market expectations of Fed hikes
have drifted low in recent weeks,
but that might well be too
optimistic. And one sort of benefit
that we could see from broadening
out of inflation is that it forces
the ECB to act more aggressively.
The ECB are now talking about 50
basis point hikes of their own,
though, as we discussed before,
European policymakers are caught
between a rock and a hard place.
If reining in inflation means higher
yields, then it could put pressure
on the banking system.
Eurozone bank balance sheets have
improved, but many are not
yet sustainable.
And the spread of Italian ten-year
yields versus the German ten-year
yield is testing a major trend.
Now charts clearly don't define the
direction, but they do highlight
the potential risks that Europe
faces if it tightens
too aggressively.
The difficulty for policymakers is
to tighten enough, but without
breaking the banks, because that's a
scenario which would put downward
pressure on the euro, creating
additional inflation, and that
could become a vicious spiral.
And all of this is taking place to
a backdrop in which wages are rising
on a nominal basis, but on
a real basis they're struggling
to keep up with inflation.
Most people consider the 1970s
as the era of stagflation.
But that period, however, saw
positive real disposable income
apart from 1974.
Both income increases and price
inflation were high, but often
income was leading, and the net
effect was a significant positive
return for real disposable income.
The last 15 years, however, have
seen US real disposable income
that's been subdued at best and very
weak in recent months.
There have been many more instances
of negative, real disposable income
in the US since 2008
than there were in the inflationary
period from the late 1960s
to the early 1980s.
We should therefore expect the US
Federal Reserve to maintain its
focus on price and not growth.
And that's because we have both
growth and higher prices in the
post-pandemic recovery.
But then eventually the higher
prices started to cap
growth. If the Fed reaction is to
immediately reverse course to
protect growth, then inflation will
continue and that will damage growth
anyway. They can't support growth
until they've tamed inflation.
Therefore, they will need to
credibly bring prices under control
in order to allow growth to
re-establish itself.
So whilst risk assets have been
bouncing and the consensus is
shifting towards the stock market
lows now being in place, the Fed's
course of action is still going to
be one which tightens financial
conditions and that could put more
pressure on equity markets.
And when we have seen inflation at
these levels over the past 50
years, we've usually been within
a recession, and recessionary events
usually lead to 35 or 40%
drawdowns in the US equity
market. And all this suggests
we should be cautious despite
that recent bounce.
And as mentioned earlier,
inflationary concerns have been
broadening out and Europe has
structural issues in its energy
markets.
I spoke with Refinitiv's Wayne Bryan
about how long these issues could
persist and what's required
to overcome them.
So Wayne, obviously there
is a near critical sort of situation
for Europe.
What is the structural issues that
Europe is facing in terms of this
energy market, particularly the gas
market, that sounds
like it's going to rumble on?
Well, yeah. I mean, it is being
overreliant on Russian gas, probably
this is the first port of call,
as you know, where we take about
40% on any given day
of Russian gas into into Europe.
Germany, quite reliant,
Italy on upwards of 30 to
50% of Russian gas.
And we've put ourselves in this
situation really.
The problem now being we've seen
some cuts to Russian gas flows
already. They're probably going to
be down about 30% this year.
What has happened is we've had
LNG in particular from
America has helped to fill the gap.
That's due to a couple of reasons,
one of them being price.
Europe was normally the balancing
market with cargoes going to Asia.
Now we see that Europe actually
is the premium market.
So we've seen a significant ramp-up
in LNG supplies
since the start of the year,
actually breaking records every
single month bar May, bar the month
of May. It's been an all-timerecord
every month, so that's kind of
helped, but the situation
as well, we need to refill our
storages.
Now without Russian gas for example,
if there's a halt on the Russian gas
flows from, say, now,
these storages don't get filled.
Of course that means the wholesale
price, which is already at record
levels, will continue to trade
higher and then that will feed into
of course, higher inflation
rate, higher energy bills, higher
energy costs all around.
So we've kind of got ourselves in
this situation really with our
over-reliance on Russian gas.
Well what sort of timeframe are we
talking about here because, you
know, in the U.S., people are
already talking about potentially
peaking inflation.
Now, it might be a peak, but will it
come down, but here in Europe, it
sounds like we're talking about a
longer-termstructural problem where
this is going to play out for quite
a long time with those energy prices
significantly higher for a
particularly long period of time?
Correct. Now, prices have come down
from the highs we saw on the 7th
of March, but have not come down
far enough. Now, while we're
still in a situation, while the war
is still happening and Russia
continues to invade Ukraine,
risk premium, as you know, is going
to stay present in contracts.
We see it on the short end of the
curve now, and not as much risk to
supply is continuing further
down the line, getting towards the
winter when demand starts to rise,
LNG imports are uncertain.
Russian gas flows then could be even
more uncertain if the war is still
going on.
That raises the prospects of a
further hike in prices, so
in terms of the price environment
now, are we're going to see over the
next couple of years, a massive
change?
You could see prices fall, of
course, but it all depends on how
much alternative supply we can
secure and how quickly.
Now, again, I've mentioned without
the Russian gas we won't fill in
storages this winter,
and that would create a huge crisis.
So what Europe is doing now
is scrambling, kind of ripping
up the sort of form book as it goes,
because what we were looking at was
in terms of decarbonisation,
energy transition, reduce
our reliance on fossil fuels,
actually, with the actual situation
now we seeing fossil
fuels even more in the mix.
For example, coal.
Due to the high gas price, we're
going to see a complete switching
from gas-firedgeneration to
coal-firedgeneration, which, as
you know, leaves a much larger
carbon footprint.
We're talking about extending the
life of coal plants in the UK.
Germany are talking about
it. We're now talking about other
means of generating, you know,
generating electricity.
So what the problem is going to be
is while this war continues,
while we don't have this additional
supply, we're
here in this high price environment,
unfortunately.
And these kind of issues, they sound
like it needs significant
investment, because everyone's talking
about the investments in obviously
sort of the environmentally friendly
renewable sources.
But there's been the underinvestment
in the fossil fuels which has
created or helped to create this
imbalance today.
Presumably, we need to build
significant infrastructures in
addition to what we think about for
the short term, to get us through
this, probably with a refocus back
on that fossil fuel spectrum, right?
Yes, correct. I mean,
interconnectivity for one is going
to help. So, for example Poland hand
their gas cut off recently
by Russia, by Gazprom, due to them
not wanting to pay in rubles.
That wasn't great. And it was going
to expire at the end of the year,
but already Poland is building the
LNG infrastructure.
They've got a pipeline that will
link them to Norway from the start
of the winter, which will help
offset that Russian gas volumes.
We're seeing other countries,
including Germany are getting
what's called FSRUs 'floating
storage regasification units'.
There's about 55 of these in
operation worldwide and they're
basically they're big floating LNG
ships that connects directly to the
grid for additional supply.
The Dutch have already secured a
couple.
They've been cut off today
from Gazprom, but
what they've done already is secure
these altentative supplies that help
offset that contract.
So the sort of market effect hasn't
been as big as it could be.
So you're seeing all these countries
scrambling to find alternative
ways, but as you rightly announce,
these cost money.
So what's happening on the
investment front now?
We're seeing more countries
actually, we're moving away
from what was going to be a spot
market purchases into more
longer-termto guarantee security
supply. And again, that flies
in the face of the energy
transition. So that,
unfortunately, is one of the
by-products of this situation.
And when we talk about how long this
is going to go on for, how long do
you think it will take for the
European market to become
self-sufficient again, i.e.
have all these, you know, whether it
be fossil fuels, renewables,
existing or whatever, all coming
together to basically say, okay, we
are now no longer reliant on that
specific import that we had before.
What sort of time frame is that
going to be?
I think it could be anything up to
at least two years.
I mean, different countries have got
different speeds of exiting Russian
gas. We've seen the ban on oil
already come into effect yesterday,
they had an agreement, but with the
gas market, they're never going to
sanction the gas market
and force Russia not to export
to Europe because that would be
economic suicide
for Europe.
So what we're going to see over
these coming years now is an
acceleration of that
investment. So we're going to need
to invest a lot more in these old,
some of these older facilities to
bring them back up to speed, like
the UK government talking about
reviving Rough, which was actually
decommissioned in 2017,
that would cost money.
If you want to extend the life of
nuclear, that costs money, if you
want to build interconnection, that
costs money. So everything we're
talking about costs money, and that
investment needs to see longer-term
contracts being signed to encourage
further investment in, as we
said, previously dwindling
fossil fuels.
So overall, you know, as you say, we
have sort of, maybe the
calm before another storm, or it may
just be the calm when things have
already settled down. But for
investors looking at Europe, there's
effectively there's an overhanging
risk premium or a risk out there,
which means that, you know, it could
flare up any time.
And we don't really have that much
control over it.
We certainly don't, and that's the
sad thing. We have no control over
this. And like I said, while this
invasion continues, this
risk premium will have to remain
because as we keep saying,
nothing is off the table at the
moment. And we're seeing that on a
week-by-weekbasis, month by month,
things we never thought would happen
are starting to happen or have been
happening. So I definitely
would say these risk premiums will
remain in place
until we see a cessation
of hostilities.
And if you've got any questions
about this episode, financial
markets or the economy, please put
them in the comments section or send
them to fmt@lseg.com.