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Financial Update from Brewin Dolphin 1 April 2022


The Weekly Round-up

Friday 1 April 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses whether the inversion of the yield curve could signal a recession in the West, and the impact of China’s zero-Covid policy.

After roaring back from their post-invasion lows, we saw a slowdown in the appreciation from markets  this week. 

Inversion

A lot of headlines were generated by the inversion of the yield curve (the yield on a two-year bond rising above the yield on a ten-year bond). This is a useful indicator because it has tended to invert ahead of recessions and, by implication, ahead of large equity market drawdowns – so apologies that we talk about it a lot. Today may be the day that the bond trading session finishes with the curve inverted. Bond yields lurched higher in response to the release of employment data for the US. The data were broadly in line with expectations in terms of the number of jobs created, figures which remain strong. The aspects that will be of note for the Federal Reserve will be unemployment, which fell to 3.6%. Prior to the onset of Covid, unemployment had reached 3.5% but, nevertheless, this is a level of joblessness which suggests a tight labour market.

The inversion of the yield curve is not a precise tool of timing. It tells you we are in the last throes of an economic expansion, but those last throes can last many months, perhaps even a year or more. And during that time equity returns have generally been pretty respectable. With that in mind, it is often appropriate to start thinking about having some dry powder within portfolios for deployment if prices fall. Earnings growth was also red hot. The annual pace of growth is the fastest in over a decade (excluding the period immediately following the pandemic, which was distorted by the types of jobs that were lost). 

Inflation

As today is the first day of April, it means we get the first estimates of inflation for the recently finished month of March, which is of course the first full month since Russia’s invasion of Ukraine. Covering Spain, Italy, Germany and France, these estimates continue to surprise analysts by the strength of their inflation. The principal driver of this is, of course, energy prices which soared after the invasion but have been very volatile since. Prices had reached over $130 per barrel but after some toing and froing they are now back down around $100. There hasn’t been too much good news to drive that. OPEC+ met on Thursday and were reluctant to provide much assistance. Members took just 12 minutes to decide to increase oil production by 432,000 barrels per month in a move designed to show how strong the unity is between members. It left little time to discuss the impact on supply from the loss of what is estimated to be around 1.5m barrels a day of Russian supply. However, by some estimates the current Covid-fighting lockdowns in China may be denting demand by around 1m barrels a day.

The Biden administration is mulling the release of 180m barrels of oil from the US strategic petroleum reserve (SPR). Historically, many commentators have observed that these kinds of releases are short lived in their impact, before attention shifts to the increased demand needed to restore the SPR back to its previous inventory. To me, it sometimes seems as if the administration is unsure how to use the SPR. It tends to act like a sort of vendor of last resort, but I wonder if it could be better employed as a sort of central bank of oil. Right now, the oil curve is downward sloping meaning that the SPR could sell oil at a higher price and commit to buying at the lower future price, either banking a profit or increasing their eventual reserves in the process. Their actions would raise the future price which would incentivise further production from producers who could be sure of the price they were receiving. 

What next?

The main controversy for investors relates to how soon a recession could fall upon us. Currently, the employment market is too strong, which tends to align with a strong environment for stocks and a weak one for bonds. That can change quite fast, but currently every indication is that companies want more staff. We are on the lookout for signs of that changing. The likely driver would be the rising amount of consumer spending that has to be channelled into non-discretionary spending. Motor fuel and food prices are rising for everyone. Utilities bills are a particular problem for those of us in Europe. Rents and house prices are rising fast in the US. Spending on discretionary consumer goods and services will reduce as a consequence. At some stage, the risk is that demand for consumer goods declines to a level below supply, at which point companies need to cut back on supply capacity and the labour market goes into reverse, followed by interest rates. These are the conditions that cause a recession, something which investors concede is required as a firebreak to end the cycle of inflating prices and wages. There will, of course, be volatility along the way, but it need not be the scarring events that we saw in 2002 or 2008.

Meanwhile in the East…

To varying degrees this is the challenge in many markets, but the one exception is China. Looking at the Chinese economy seems almost like going back in time to the middle of 2020. China has just completed the first of two lockdowns in Shanghai, during which residents are not permitted to leave their homes except to go to mandatory testing sites. The two lockdowns are lasting four days each, with the first covering the east of the city and the second covering the west. It is indicative of a heavy-handed Covid suppression policy that the Chinese Communist Party is having to impose in order to minimise the rise in infections. In China there is virtually no natural immunity, the prevailing vaccine seems very ineffective against Omicron and vaccine take up is quite low even amongst cohorts of the population. The lockdowns are already evident in the disappointing purchasing managers’ indices that were released this week, but the situation is sure to deteriorate further.

China’s zero-Covid policy is a problem for its own economy where growth targets are being slashed during the year of Xi Jinping’s desired coronation, due at the National Congress of the Chinese Communist Party which will take place in the second half of this year. Nobody doubts this will take place and yet one has to wonder what impact the bungled Covid response is having on his standing within the party.

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