Your weekly economic update from the team at FXD Capital
Over the weekend, Bank of England governor Andrew Bailey spoke to the G30 group of central bankers. In the discussions, he remarked that the bank would “have to act” to curb inflation. The pressure of rising energy prices and supply chain issues is coming to a head quickly for the central bank, and all signs point towards December and February for a rate hike. New chief economist Huw Pill thinks the decision will come even sooner, with November being the time, off the back of inflation reaching an anticipated 5%. While such hikes are likely to take us back to the old-new levels of 0.5-0.7%, the speed of the change is in marked contrast to other nations.
The ECB seems largely sanguine about any increases and markets price the Federal Reserve bolting the horse next September.
As markets opened on Monday, gilts began to digest the news, and the 2-year mark hit 0.73%, the highest level since May 2019 (10-years are at 1.16%). Sterling is also proving buoyant on the carry trade, passing 1.38% and looking towards the psychological barrier of 1.40.
The big conundrum for money managers is where to put money when rates start to hike. Stock markets have continued to drag themselves kicking and screaming to new highs because they present the lesser of two evils for investors. While stocks would be presumed to fall as rates rise (due to increased discount rates), they remain resilient in the face of impending doom.
The reasons are both down to company performance and investor sentiment. Regarding the former, company earnings have held up well in 2021, despite inflation pressures, which the market has rewarded. Moreover, profitability is holding up because companies are passing on cost increases to consumers; this bodes well for quality brands and discounters alike. As such, the stock market will likely diverge as the proverbial hits the fan, with quality stocks (both of the growth and income ilk) holding up and value plays taking the brunt.
Stocks are also remaining persistent because of the lack of alternatives. Corporate bonds (in the current environment) are a poor man’s equity – low income and no growth upside. So naturally, government bonds are on shaky ground and likely to never return; hence, investors are sticking with equities. While commodities and alternative assets (ranging PE, VC, crypto, real estate and infrastructure) all have their merit, it’s the liquidity of equities that draws moths to the flame.
Indeed a survey this week by Bank of America of 420 fund managers found that cash reserves are sitting at 4.7% of AUM, their highest for a year. So cash balances are creeping up in anticipation of a crash, but also a Black Friday-esque shopping spree of the initial whipsaw that will hit stock markets. Corporate treasurers are likely following suit, and call accounts will be making a brisk trade to the detriment of fixed deposits.
The death of the bond has long been suggested, and it’s even raising questions about whether the standard 60/40 allocation between stocks and bonds will continue. However, I doubt that will happen so much, as rising yields will tempt investors back once the dust settles. But the 40 element will likely become more nuanced, with non-bond assets like gold and derivatives offering alternatives.
The Fed’s Beige Book report released on Wednesday showed that economic growth “downshifted” in June and July, which, I guess, we already knew! Further detail showed that it was indeed down to the post-pandemic bounce of leisure and dining pursuits tailing off. The report acknowledged labour pressures but noted that lower-wage earners saw pay increases due to the supply shortage. This is an excellent juncture to return to the inflation issue at hand: if companies are passing on costs to consumers and consumers are earning more, then there could be an equalising effect at hand.
While it’s likely that there will be pain for consumers and rate increases will also lead to a significant bellow from mortgage borrowers, there are also signs that perhaps normalcy may prevail. We have not seen hyperinflation in the internet era, correlation or causation? One significant benefit of the internet versus the analogue period is the benefit of discovery. Maybe consumers are flexing their purchases more, switching to Aldi from Waitrose as prices of energy rise.
There may not be so much pain ahead of us after all; it could be that consumers have been trained and enabled to be more promiscuous with their brand loyalty, and it will be the middle of the road brands that feel more effects from inflationary pressure?
All the best for the week ahead
Alex
Our weekly column is written by Alex Graham, Economic Advisor to FXD Capital. Originally a bank treasurer, Alex’s weekly roundup intends to provide a conversational, top-down view of what is going on in world macroeconomics and how it impacts business on the ground level.
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