BlueBay AM: Brits need a new Thatcher – but don't hold your breath for one
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The Jubilee provided much-needed cheer, but soaring inflation and looming strike action are also giving us cause for reflection.
Global yields have pushed higher over the past couple of weeks, as inflation concerns continue to linger. Eurozone inflation exceeded 8% in May and is yet to turn lower, with a peak around 9% likely towards the end of Q3. In light of this, the European Central Bank (ECB) has been forced to move in a more hawkish direction, bringing forward anticipated rate hikes, with the repo rate projected to rise by approximately 125bp by the end of 2022, taking rates to 0.75%.
Ultimately, we believe that slowing growth in the eurozone may see inflation fears fade quickly towards the end of the year and this may mean that the future path of rates is over-priced. However, until price pressures start to fade, it may be difficult for yields to stabilise.
Meanwhile, pressure continues to build on eurozone spreads, given limited ECB detail with respect to measures that may be aimed at containing possible fragmentation risk. Eurozone corporate spreads have also widened in response to rising inflation forecasts and falling growth forecasts. For now, it appears that spreads in the periphery will still need to go wider, before policy makers feel obliged to react to this.
In the US, the data backdrop is somewhat more constructive. Having peaked at 6.5%, the US Core Consumer Price Index (CPI) is expected to drop below 6% in May data, which is due to be released later today. In this context, there is some suggestion that Fed actions are starting to have the desired effects in the wake of a rapid tightening of financial conditions.
However, we expect the Federal Open Market Committee (FOMC) to remain on a hawkish path until price pressures are much more benign. We see US rates rising towards 3% by the end of the year, as the Fed front-loads its tightening in the hope of restoring price stability as quickly as possible, in order to avert a de-anchoring of inflation expectations.
US economic activity data remains relatively healthy and with consumer and business balance sheets in strong shape, we continue to see recession as a risk case, rather than a central probability. Further evidence of the underlying strength of the US economy is shown in fiscal data, with the US Federal deficit shrinking at a rapid rate.
Through the end of last year, the US budget balance had been deep in negative territory and it may have been widely assumed that prior tax cuts would need to be reversed in the wake of the pandemic. Yet what has recently been witnessed could be heralded as a triumph of Laffer economics, with prior tax cuts helping to propel growth to an extent that these tax cuts have been shown to be self-funding.
The growth outlook in Europe remains much weaker and it is a 50/50 call in our eyes, whether Europe will experience a contraction in GDP in the final quarter this year. The cost-of-living crisis continues to weigh heavily on economic and business sentiment across the continent.
However, we would observe that wage demands coming out of Germany remain relatively well contained, with unions, employers and the government seeking to promote the importance of a social contract, such that a return towards a 1970s type of spiralling wage setting seems unlikely to take hold. Yet, this is not the case across the Channel.
In the UK, labour shortages compounded by Brexit have seen wage demands accelerate and industrial strike action boom. With the Bank of England prepared to let inflation run, an absence of leadership appears to be feeding into a de-anchoring of inflation expectations, with more bad news on a weekly basis.
Although Boris Johnson survived a leadership challenge earlier this week, he is now badly wounded. This may see policy move in a more populist direction, with taxes being cut and the Northern Ireland protocol being suspended, risking a dispute with European trading partners. These steps may add to inflation and put pressure on the pound.
We retain a bearish view on UK assets and the currency and have added to short sterling positions over the past several days, as we struggle to build a more constructive case for the UK in the weeks and months ahead. The UK is already experiencing stagflation and these pressures seem likely to intensify, with the outlook for growth and inflation both deteriorating.
Meanwhile developments in Japan continue to attract increasing interest. Bank of Japan (BoJ) attachment to Yield Curve Control has seen the yen continue to slide as interest rate differentials continue to rise.
With this adding to inflation, we think that we may be moving to a point where the BoJ needs to change course. Were this to happen, we may look for a material move higher in JGB yields, making a short duration stance in Japan an attractive position to maintain, in terms of a prospectively asymmetric, forward-looking return profile.
Elsewhere in Asia, authorities in China have wanted to feel vindicated that Covid has fallen back, in the wake of draconian lockdowns. However, with cases picking up in Hong Kong and now Shanghai, we expect any reprieve to be temporary in nature, leading to a stop / start growth pattern.
Within emerging markets more broadly, we continue to be focussed on winners versus losers, in the context of the terms of trade shock. We think we could be sliding towards the imposition of currency controls in Turkey and would also highlight the rapidly deteriorating balance of payments in India. Elsewhere, commodity exporters remain in a much stronger position.
Looking ahead
Today’s US CPI report may be significant in determining market direction. A more benign outcome could see long dated Treasury yields continue to consolidate in a range around 3%. However, any disappointment on the topside could see yields push higher once more and if this is the case, we think this would likely weigh on risk assets. A number of anecdotal pieces of evidence have made us somewhat more optimistic on the US inflation outlook.
However, data from elsewhere around the globe appears to suggest that inflation prints continue to be skewed towards exceeding market expectations and this gives pause for concern. Yet, at least in the US, what we appear to be witnessing is the product of an overheated economy and so interest rates are rising for the ‘right’ reasons, when this is simply not the case elsewhere.
In the UK, the Jubilee has provided a welcome distraction, but as demonstrated to those travelling through the country’s airports recently, there is a growing and palpable sense that the country is heading very much in the wrong direction.
In particular, a benefits and entitlement culture seems to have become entrenched such that labour force productivity is becoming hamstrung by work-shy attitudes and a sense that workers should be free to pick and choose how, where and when they want to work.
This ‘back-to-the-70s’ narrative may have further to run and it is tempting to think that a new Thatcherite moment will be needed at a future point. Yet we remain several years from society acknowledging or embracing this eventuality, and there is no obvious or emerging leader who appears to fit this mould to be found anywhere on the horizon. For the time being, it looks like we are stuck with our resident buffoon for a while longer.