Financial Update from Brewin Dolphin - 20 May 2022

May 2022

Friday 20 May 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses rising bond yields, the surge in UK inflation and China’s interest rate cut.

European stocks seem to be finishing this week little changed, despite the turmoil we have seen in the markets. Asian stocks have generally had quite a good week, while the US has been the worst performer.

Although we have seen some steep falls in US equity markets, it has been the dollar that has left US investments trailing. The dollar has been the standout performer since the second quarter of 2021, relative to which the pound, euro and yen have underperformed fairly consistently. Dollar exposure is particularly attractive at a time when you anticipate weaker economic growth because it tends to perform well during those times as demand for low-risk assets such as US treasuries increases.

Interest rate trajectory

That has not been the dynamic driving the dollar higher so far this last year though. Instead, it has been the realisation that US interest rates would rise faster than those in other regions. Foreign exchange investors would receive more interest for holding US bonds than they would for any other region. Of the major currencies, the UK offers the second-highest yield and the euro is the least attractive due to its negative interest rates in recent years. Interest rates in Japan are higher than those in the eurozone, but the crucial difference is that rates are expected to start rising in Europe from July whereas in Japan they will remain very slightly negative.

In Europe, interest rates will return to zero in the third quarter of this year with two or three interest rate increases. This will not, however, narrow the gap between Europe and the US where rates are not only much higher but are expected to continue to rise much faster. Interest rates will rise at a rate of 0.25% per meeting in the eurozone while in the US they rise at a rate of 0.5%.

We have also heard from various Federal Reserve members that we should see rates reach a neutral rate by around the end of this year. This is the rate at which interest rates are considered to be neither stimulating nor suppressing economic activity. The desire to get back to neutral and go beyond it reflects the widely acknowledged tightness of the labour market and that while there remain multiple open jobs for each unemployed person, the bargaining power of current and prospective workers will be high. This raises the potential for the high prices consumers are suffering to lead them to demand higher wages, which in turn might need to be funded by raising prices – the much-feared wage-price spiral.

Bond yields increasing

So it seems as if interest rates have higher to go, but bond yields have caught a bid more recently. Sentiment has been very poor towards bonds after they suffered a dramatically poor first quarter of 2022. Since then, yields have improved significantly and are offering better value. That said, with interest rates expected to rise all through this year it would be very unusual for bond yields to have peaked this early.

The factor that would cause them to peak sooner would be a deterioration in economic momentum. So far, the economy seems to be continuing to expand with employment increasing and wages rising. Last week’s consumer price data for the US did show inflation slowing but not as much as had been hoped. One of the most persistent elements of the inflationary data was the statistical reflection of rising rents, which themselves reflect rising house prices. Housing has been incredibly strong, bolstered by low interest rates, a shortage of supply and people’s desires to change their homes as agile working becomes more prevalent. However, recent increases in bond yields are making mortgages more expensive.

This week’s National Association of House Builders (NAHB) survey showed that members are anticipating a slowdown in demand for new houses. If that comes to pass and is crucially reflected in moderating house price increases, then that would be helpful in cooling inflationary pressures.

UK inflation surges

In the UK, the inflationary picture looks more severe, particularly this month, but that reflects the abrupt change in the domestic energy price cap change that hit during April. That explained most of the extraordinary 2.5% monthly increase in prices and the 9% annual increase. With such a sharp hit to disposable incomes, it was a little surprising to see how robust retail sales were during April, but the full impact of the price increases and the higher rate of national insurance chargeable in the same month will be felt during May. Prices rose for restaurants and hotels, but retail sales figures showed more food and alcohol being purchased, suggesting at least some people were eating and drinking at home – either to avoid higher prices or because they can’t get a table.

This week also showed that the UK employment market remains tight with high jobs growth during March and PAYE data suggesting it strengthened further during April. Although there have been much publicised plans to cut public sector jobs in general, the labour market continues to suffer from shortages of candidates. The data was distorted for the last few years by the loss of low wage positions, but now the underlying trend of wage growth looks as strong as it has been since the global financial crisis. In fact, when bonuses are included, wages are growing at their strongest pace since 2000. Understandably, therefore, the Bank of England remains committed to raising interest rates further.

China cuts interest rates

In stark contrast to the rest of the world, China announced a cut to interest rates this morning. The economy has been hit hard by Covid suppression measures. China is cutting the five-year prime rate which serves as an anchor for mortgages. Banks had already been cutting mortgage rates prior to this official rate change. Loan demand fell sharply during April as home sales declined.

In addition to the national cut in mortgage rates, China has also launched additional measures in specific cities including subsidies to buy homes, perks for those with multiple children (to address China’s demographic challenges) and loosening restrictions on mortgages. It follows a cut to the rate on new mortgages of 20 basis points, which was only announced last Sunday.

This week had seen China starting to relax the lockdown measures in Shanghai that have been necessitated by its controversial zero-Covid policy. Within days of the first measures being lifted, China acknowledged three new cases had been found outside the government quarantine. The whole world is keen to see China reopen to relieve supply chain pressures, but the country remains committed to eliminating the spread of Covid in the community.