United Kingdom

The pain grows for UK businesses and consumers

There have been more stories over the course of the last week of the damage being wrought to the UK economy because of the combination of high energy and food prices, increasing interest rates and the hangover of tax increases. The latest warnings came from the hospitality sector, that warned many of its members were set to go out of business without targeted support from the government to address sharply increasing energy bills. This comes on top of increased industrial action at the UK’s ports, on the railways, in public services and threats of strikes from teachers and healthcare workers. The prospect of a sharp increase in industrial action in the run up to Christmas is only likely to deepen the UK economy’s downside risks, in my view.

Despite signs of increasing economic stress, the markets continued to ratchet up interest rate hike expectations. The markets price in a rate peak of over 4.25% in the UK, something that is highly likely to further worsen the economic outlook, given the pressures that the economy finds itself under. This increase in UK interest rate expectations hasn’t supported a recovery in the GBP however, which last week dipped back below $1.18, and below $1.1650 at the beginning of this week. There is further downside risk to the GBP, as the problems that lie ahead for the economy seem of a greater magnitude than those in the US or Euroland, in my opinion.

There are limited economic releases of interest for the markets this week. Indeed, we’ve already seen the release of the consumer borrowing data from the Bank of England for July, which reported a further increase in net unsecured consumer credit, and a marginally larger than expected increase in lending secured on dwellings. Over the remainder of the week, I suspect we will see a weakening in the Lloyds business barometer for August, a sharp slowing in the pace of house price growth according to the Nationwide survey for August, and confirmation of a contraction in manufacturing, from the final August CIPS PMI (Chartered Institute of Purchasing and Supply’s Purchasing Managers’ Index) survey.

Nothing in these releases to help the GBP recover, nor support the case for such significant additional monetary tightening from the Bank of England as is priced into the markets. The central bank already suggested that inflation would undershoot significantly in its August Monetary Policy Report, and the markets have added a further 50 basis points of tightening since then. Could this be another source of GBP weakness in the months to come?

Europe

Consumer Price Index inflation likely to surge again

The Euroland inflation data for August is due for release this week. Market consensus forecast is for it to rise to 9% year-on-year from 8.9% in July, with a small risk of an overshoot. The European Central Bank will be watching the outturn closely and readying a response to the latest developments in inflation, and inflation expectations at next Thursday’s Governing Council meeting. The markets are well positioned for a further 50 basis point increase in all the main Euroland interest rates at this meeting, with a further significant hike likely to come in October as well. 

However, the European authorities are expected to have a significant headache regarding interest rates because of the weakening in the economy, as demonstrated by last week’s survey evidence and figures already released this week. Notably, last week’s manufacturing and services PMI indices from Euroland pointed to a further contraction in activity in August, larger than the one recorded in July. That was supported by the release of Euroland confidence indicators for August on Tuesday of this week, which record a larger than expected drop in both industrial and services confidence.

Whatever the central bank does, this dichotomy between inflation and activity is only likely to cause the EUR another headache. It has spent more time trading under parity against the USD, and it is unlikely that EURUSD has yet found its base. More pressure may be brought to bear on the EUR in the remainder of this week, with French consumer spending data for July, and a number of unemployment releases due from Euroland.

If higher interest rates are already priced in, exactly what will turn the EUR around? It is worthwhile noting that the EUR is performing better against the GBP, suggesting that there is a perceived heightened relative risk to the UK than the Euroland economy, at least as far as the markets are concerned. There may be further chance for the EUR to appreciate against the GBP, if the economies pan out as I suspect they will.

United States

Equity markets now in the Fed’s crosshairs

The US Federal Reserve’s Jackson Hole symposium prompted a sharp sell-off in equities and risk following comments from Chair Jerome Powell and other Fed members that pointed to ongoing aggressive tightening. The equity markets lost around 3% of their value in that sell-off, something that Minneapolis Fed President Kashkari thought was the markets taking the Fed’s inflation busting stance seriously. It could be something far worse though, in that the markets might be losing faith in the Fed’s ability to control inflation and, worse still, the damage that is being done to the US economy in the face of this inflation problem.

Historically equity markets stand up reasonably well in the face of inflation, given the impact that said inflation is likely to have on gross earnings and profits. But is it different this time, given the inflation is predominantly in necessity items such as energy and food? It would appear that the Federal Reserve thinks that the economy and financial markets can withstand much higher interest rates, but the reality is that it doesn’t know what the effects of higher interest rates will be on the US economy, with much yet to be fully or even partially exposed.

This week culminates with the release of US non-farm payrolls data for August. The US labour market is still relatively strong and enjoyed strong payrolls growth in July. Will it be able to sustain that momentum, or are the signs of slowing in other parts of the economy finally likely to catch up with the labour market? Whatever the outturn with regards to payrolls, the signals from other parts of the US economy are expected to worsen this week.

As for the US dollar, it has benefited from the US authorities continuing to talk tough. I suspect that the dollar index could make fresh highs in the next week or two, with the recent multi-decade high of 109.478 having been reached yesterday and less than 1% away from current levels. There is the potential for a further 5-6% of additional USD gains in my view, based on dropping risk appetite and ongoing aggressive monetary policy tightening from the Federal Reserve.

Central banks

Israel, Indonesia, Iceland and Korea hike last week; Hungary holds the spotlight this week

Last week saw the central banks of Israel, Indonesia, Iceland and Korea all hike interest rates, with the hikes from Israel and Indonesia exceeding market expectations. The reasoning from most of these central banks for the hikes was centred on the inflation fight, but one that most central banks appear to be losing at the moment, given that the inflation rates continue to increase beyond the targeted rates for all of these countries. The hikes in interest rates are clearly having a negative effect on economic activity, but lagged effects of higher energy and raw material prices potentially have further to run. Moreover, the effects of inflation on disposable incomes and the lagged effects of higher interest rates could make it hard for consumers to recover quickly, even if central banks reverse course quickly on interest rates and inflation drops away. For most central banks the challenge may not be whether they can bring inflation under control, but what do they do once it is back to, or below, target?

This week sees the Hungarian central bank in the spotlight, with no other notable decisions due. The market expectation is for a further 1 percentage point hike to interest rates, taking the base rate to 11.75%. That would leave it at its highest rate since 2004, when the Hungarian economy looked markedly different to how it does today. I think the Hungarian central bank may soon signal that it is close to the peak level for interest rates, but it will first want to ensure that the risks of additional HUF depreciation has disappeared, in my opinion.