Musings on Markets (Dated 20/05/2022)

There are two main fears driving markets:

1. Fears over inflation becoming embedded (‘sticky’), resulting in upward revisions in rates expectations.

2.Fears over macroeconomic growth & the potential for recessions in the US & Europe.

With the SPX -c.18% YTD, and XOVER standing +231bps on the year at c.488 it’s natural that markets are fearful. However, to avoid sounding overly dreary, we arguably have a better handle on the path of rates than we did at the start of the year, and there has been significant repricing of risk.

With that in mind, let’s dive into the issues driving markets this week.

FED chair Jerome Powell spoke to the Wall Street Journal last Tuesday, delivering a series of hawkish comments which sent the SPX down 4%.

Briefly, Powell commented that the FED would “do what it takes” to get inflation down to their 2% target, and went as far to say that the FED would raise rates above the FED’s neutral rate (interest rate at full employment) if needed. Powell also stated that he sees the natural rate of unemployment (full employment) at 5%, rather than the current 3.8%.

Meanwhile in the UK, the bank of England’s chief economist Huw Pill spoke on friday morning. He noted that inflation was likely to be “much worse than feared”, noting that “The BOE expects inflation to reach 10.2% in October, up from a 40-year high of 9% currently.”.

Pill also drew attention to the importance of preventing inflation from becoming entrenched. In light of a tight labour market, strong wage growth, and expectations from UK producers that they will re-establish margins via price rises.

Andrew Bailey (BOE Governor) spoke on Tuesday, he underlined that UK inflation was being driven by exogenous supply side shocks (namely UKR war, COVID). He drew particular attention to Ukraine’s role as one of the world’s largest producers of agricultural produce. With Ukraine’s port’s currently blockaded by Russia, the war is driving food prices higher across the globe, which could have dire consequences for emerging markets, and put further pressure on consumer spending power in developed economies.

Keeping with supply side shocks, we’d also highlight a note from Reuters warning of a shortage of refining capacity. “The post-pandemic economic boom in 2021/22 has exceeded the capacity of refineries to make enough (gasoline)… and has severely depleted inventories across North America, Europe and Asia:”, the note continues “In recent decades, distillate shortages have always been resolved by either a mid-cycle slowdown or an end-of-cycle recession and there is no reason to think this instance will be different.”.

Turning back to the consumer, this week UK consumer sentiment printed at c.-40, the lowest in 48 years. Suggesting that consumers are feeling the squeeze from the cost of living crisis (negative for consumer demand & growth).

In the US spending data shows large declines in consumer spending on discretionary items (Recreational -21%, Airfare -15%, Alcohol -15%, Furniture -15%), while spending on essentials such as Gas, car insurance, and housing were slightly positive.

We also had bellwether US retail reporting this week, broadly speaking inventories were up sharply, reflecting price increases but also consumers pulling back on discretionary items (see data on spending patterns above).

Stepping back, the various signs pointing towards a weaker consumer (commodity price increases, impact of prev. price rises on consumption patterns) lead towards weaker growth outlooks across the UK & Europe, which in conjunction with warnings over stickier CPI, give credence to stagnationary downside scenarios.

Nevertheless we have seen significant repricing in both rates & credit YTD, as noted above markets probably have “further to go”, but now see average yields on BB, B, and CCC GBP HY indices standing at 6.37%, 9.16% and 20.18% respectively.

Rounding off, we would mention that China’s central bank cut long end rates on Friday, which saw the Hang Seng jump some 3%, albeit this comes amid a zero policy covid backdrop which continues to strangle growth.

In terms of Credit GBP, HY Corporates returned c.-33.49 basis points (bps) on the week, with Financials under-performing Non-Financials each returning c.-32.57 bps. In terms of rating, Double BBs returned -8.8bps, whilst Single Bs and CCCs returned –66.08bps and -247.12bps respectively. (iBoxx)

At time of writing (Friday, evening) The FTSE gained 1.51% on the week. GBP / USD is up 0.49% on the week at c.1.3602. The spread on the iTraxx Crossover (XOVER) – a proxy for the market’s assessment of credit risk (the greater the spread, the greater the perceived risk) increased by 38bps over the week to 488 (Bloomberg).