Gasflation if not Stagflation

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Global equities ended last week unchanged despite a further surge in gas prices and step-up in bond yields. At their low point a week ago, markets were in spitting distance of recording a 5% decline from their early September high but are now down a more modest 3% or so.

Bond markets, however, sold off further with UK government bonds hit hardest. 10-year UK gilt yields rose another 0.2% over the week to 1.20%, double their level a couple of months ago. This in turn has left these so-called risk-free assets nursing losses of as much as 5% over the past month.

We have been fearful of such a sell-off for a while and have only limited exposure to government bonds. This, along with the relatively short maturity of our fixed income holdings generally, has meant our lower risk portfolios have held up relatively well over this period.

The bond sell-off is a result of markets now pricing in a much sooner and sharper rise in UK rates than before. Following hawkish comments from the Bank of England, investors are now assuming rates rise from their current 0.1% to 0.9% by the end of next year.

The latest cause for concern is obviously the surge in wholesale gas prices which have risen six-fold since the start of last year. They shot up even further last week before falling back after President Putin suggested he might be willing to increase supplies. The problems have been caused by a perfect storm of strong demand, weak supply, a lack of storage and low inventory levels. Shortages could yet become worse, if there is a cold winter, before they get better.

The surge in gas prices is having knock-on effects on other energy prices as well. Even so, the current rise is a pale imitation of the commodity price surges behind the double-digit inflation of the 1970s. Back then, commodity prices doubled or even tripled. This time, prices are up sharply from the lows of last year but are up only 30% or so on 2019 levels and remain below where they were in the years following the global financial crisis. It should also not be forgotten, despite current appearances to the contrary, that the global economy is much less dependent on commodities than fifty years ago.

Still, commodity prices are clearly exacerbating the upward pressure on inflation already coming from shortages in other areas. UK inflation now looks set to hit at least 4.5% next spring before falling back. The Bank of England’s worry is that this spike could fuel a rise in inflation expectations and increase the risk of a wage-price spiral.

In the US, the Fed’s tightening plans hinge not only on inflation developments but also the state of the labour market. Friday’s figures showed a considerably smaller increase in employment in September than expected. QE tapering will still probably start in November as the Fed intended but this is now rather less of a done deal.

Inflation looks set to remain a source of worry for markets well into next year and upward pressure on bond yields is likely to continue. That said, the big shift in tightening expectations should now be behind us and we expect further rises in yields to be much more moderate. Indeed, the experience earlier this summer, when yields fell back sharply despite inflation worries worsening, highlights that even in a bond bear market, there can still be sizeable counter-trend rallies.

As for equities, volatility has been surprisingly low this year and we expect the recent rise to more normal levels to continue. Not only is policy turning less supportive but so also is the corporate earnings environment. The third quarter reporting season kicks off in the US this week with the banks and S&P 500 earnings are forecast to be up 30% on a year ago.

This is a hefty gain but a far cry from the 95% rise seen last quarter and growth is set to slow further into next year. US profit margins are currently at record levels and the surge in raw material prices, together with higher labour costs, will be a headwind going forward.

All the same, as long as demand remains quite strong which we expect, this should not prevent further gains in earnings even if growth is much lower than seen over the last year. Continued earnings gains are the main reason why we still believe equities have further upside in the medium term even if they face more choppy waters near term.

Rupert Thompson

Chief Investment Officer