The Big Conversation
Episode 127: Is inflation spreading?
This week Roger Hirst looks at the recent break out in crude oil prices and the ongoing squeeze in agricultural products. US inflation may have peaked in H1, but that doesn’t mean it will quickly drop back to ‘normal’ levels. Furthermore, if it continues to spread from durable goods to essentials such as food and energy, then the Fed may have an even harder job on its hands.
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Roger [00:00:00] Whilst there are calls for US inflation to peak this quarter, inflation is spreading further afield and becoming embedded in other goods, especially food products, which will have far more impact on consumer sentiment than the durable goods which was soaring last year. And a broadening out of inflation, whilst it may not necessarily drive headline inflation higher, the impact on consumers could spur yet more action from a greater number of central banks, putting even more pressure on global financial conditions. And that's what we're going to look at today in The Big Conversation.
Roger [00:00:35] Over much of the last year, inflation was primarily about surging input prices for producers, leading to some eye-watering levels of producer price inflation. Whilst PPI is generally much more volatile than CPI, some of these moves were still extraordinary. For consumers in the US it was more about the rise of durable and consumer goods with lumber and second-hand car prices leading the way and helping push CPI to a 40-year record. And Europe was severely impacted by issues across the energy sector, and that was before the war in Ukraine, which then saw energy prices take yet another leg higher. And in the US, gasoline prices have already topped $4.50, with many predicting $8 or more, as well as potential rationing. The recent breakout of a consolidation pattern in crude oil is another ominous sign. Brent has recently touched its highest level since the margin shock in March. Today's prices are being driven more by fundamentals than they were a couple of months ago. Although month end expiry did play a part for Brent, but the real headache for central banks across the world is the rise in food prices. In many regions, food prices are only a small percentage of the shopping basket. But it's still a painful reminder of choices that many families will need to make. And in other less affluent regions, there are no choices when food prices surge. There are many countries who have historically subsidised essentials like food and energy, but that's not an open-ended game. Eventually, subsidies become a drain on government finances, which can negatively impact a country's currency and increase the inflationary shock on government balance sheets, or the subsidies are capped and the higher costs eventually are passed on. So whilst the potential peak in CPI may ease some of the short-term pressures on US policymakers, there is still a potential for inflation expectations to become unanchored. Often policymakers will respond to the market price of inflation rather than the actual level of spot inflation. Though both will be taken into consideration. The US five-year inflation rate in five years time hit 2.8% on an intraday basis on Tuesday, very close to the recent highs before then closing lower on the day. Inflation expectations often follow the gyrations in the oil price, so if crude moves through the highs, then inflation expectations are likely to follow. And rather than pulling back from the current rate-hiking trajectory, the Fed may therefore need to act decisively to maintain credibility. The market expectations of Fed hikes have drifted low in recent weeks, but that might well be too optimistic. And one sort of benefit that we could see from broadening out of inflation is that it forces the ECB to act more aggressively. The ECB are now talking about 50 basis point hikes of their own, though, as we discussed before, European policymakers are caught between a rock and a hard place. If reining in inflation means higher yields, then it could put pressure on the banking system. Eurozone bank balance sheets have improved, but many are not yet sustainable. And the spread of Italian ten-year yields versus the German ten-year yield is testing a major trend. Now charts clearly don't define the direction, but they do highlight the potential risks that Europe faces if it tightens too aggressively. The difficulty for policymakers is to tighten enough, but without breaking the banks, because that's a scenario which would put downward pressure on the euro, creating additional inflation, and that could become a vicious spiral. And all of this is taking place to a backdrop in which wages are rising on a nominal basis, but on a real basis they're struggling to keep up with inflation. Most people consider the 1970s as the era of stagflation. But that period, however, saw positive real disposable income apart from 1974. Both income increases and price inflation were high, but often income was leading, and the net effect was a significant positive return for real disposable income. The last 15 years, however, have seen US real disposable income that's been subdued at best and very weak in recent months. There have been many more instances of negative, real disposable income in the US since 2008 than there were in the inflationary period from the late 1960s to the early 1980s. We should therefore expect the US Federal Reserve to maintain its focus on price and not growth. And that's because we have both growth and higher prices in the post-pandemic recovery. But then eventually the higher prices started to cap growth. If the Fed reaction is to immediately reverse course to protect growth, then inflation will continue and that will damage growth anyway. They can't support growth until they've tamed inflation. Therefore, they will need to credibly bring prices under control in order to allow growth to re-establish itself. So whilst risk assets have been bouncing and the consensus is shifting towards the stock market lows now being in place, the Fed's course of action is still going to be one which tightens financial conditions and that could put more pressure on equity markets. And when we have seen inflation at these levels over the past 50 years, we've usually been within a recession, and recessionary events usually lead to 35 or 40% drawdowns in the US equity market. And all this suggests we should be cautious despite that recent bounce. And as mentioned earlier, inflationary concerns have been broadening out and Europe has structural issues in its energy markets. I spoke with Refinitiv's Wayne Bryan about how long these issues could persist and what's required to overcome them.
Roger [00:05:53] So Wayne, obviously there is a near critical sort of situation for Europe. What is the structural issues that Europe is facing in terms of this energy market, particularly the gas market, that sounds like it's going to rumble on?
Wayne [00:06:06] Well, yeah. I mean, it is being overreliant on Russian gas, probably this is the first port of call, as you know, where we take about 40% on any given day of Russian gas into into Europe. Germany, quite reliant, Italy on upwards of 30 to 50% of Russian gas. And we've put ourselves in this situation really. The problem now being we've seen some cuts to Russian gas flows already. They're probably going to be down about 30% this year. What has happened is we've had LNG in particular from America has helped to fill the gap. That's due to a couple of reasons, one of them being price. Europe was normally the balancing market with cargoes going to Asia. Now we see that Europe actually is the premium market. So we've seen a significant ramp-up in LNG supplies since the start of the year, actually breaking records every single month bar May, bar the month of May. It's been an all-time record every month, so that's kind of helped, but the situation as well, we need to refill our storages. Now without Russian gas for example, if there's a halt on the Russian gas flows from, say, now, these storages don't get filled. Of course that means the wholesale price, which is already at record levels, will continue to trade higher and then that will feed into of course, higher inflation rate, higher energy bills, higher energy costs all around. So we've kind of got ourselves in this situation really with our over-reliance on Russian gas.
Roger [00:07:35] Well what sort of timeframe are we talking about here because, you know, in the U.S., people are already talking about potentially peaking inflation. Now, it might be a peak, but will it come down, but here in Europe, it sounds like we're talking about a longer-term structural problem where this is going to play out for quite a long time with those energy prices significantly higher for a particularly long period of time?
Wayne [00:07:54] Correct. Now, prices have come down from the highs we saw on the 7th of March, but have not come down far enough. Now, while we're still in a situation, while the war is still happening and Russia continues to invade Ukraine, risk premium, as you know, is going to stay present in contracts. We see it on the short end of the curve now, and not as much risk to supply is continuing further down the line, getting towards the winter when demand starts to rise, LNG imports are uncertain. Russian gas flows then could be even more uncertain if the war is still going on. That raises the prospects of a further hike in prices, so in terms of the price environment now, are we're going to see over the next couple of years, a massive change? You could see prices fall, of course, but it all depends on how much alternative supply we can secure and how quickly. Now, again, I've mentioned without the Russian gas we won't fill in storages this winter, and that would create a huge crisis. So what Europe is doing now is scrambling, kind of ripping up the sort of form book as it goes, because what we were looking at was in terms of decarbonisation, energy transition, reduce our reliance on fossil fuels, actually, with the actual situation now we seeing fossil fuels even more in the mix. For example, coal. Due to the high gas price, we're going to see a complete switching from gas-fired generation to coal-fired generation, which, as you know, leaves a much larger carbon footprint. We're talking about extending the life of coal plants in the UK. Germany are talking about it. We're now talking about other means of generating, you know, generating electricity. So what the problem is going to be is while this war continues, while we don't have this additional supply, we're here in this high price environment, unfortunately.
Roger [00:09:40] And these kind of issues, they sound like it needs significant investment, because everyone's talking about the investments in obviously sort of the environmentally friendly renewable sources. But there's been the underinvestment in the fossil fuels which has created or helped to create this imbalance today. Presumably, we need to build significant infrastructures in addition to what we think about for the short term, to get us through this, probably with a refocus back on that fossil fuel spectrum, right?
Wayne [00:10:04] Yes, correct. I mean, interconnectivity for one is going to help. So, for example Poland hand their gas cut off recently by Russia, by Gazprom, due to them not wanting to pay in rubles. That wasn't great. And it was going to expire at the end of the year, but already Poland is building the LNG infrastructure. They've got a pipeline that will link them to Norway from the start of the winter, which will help offset that Russian gas volumes. We're seeing other countries, including Germany are getting what's called FSRUs 'floating storage regasification units'. There's about 55 of these in operation worldwide and they're basically they're big floating LNG ships that connects directly to the grid for additional supply. The Dutch have already secured a couple. They've been cut off today from Gazprom, but what they've done already is secure these altentative supplies that help offset that contract. So the sort of market effect hasn't been as big as it could be. So you're seeing all these countries scrambling to find alternative ways, but as you rightly announce, these cost money. So what's happening on the investment front now? We're seeing more countries actually, we're moving away from what was going to be a spot market purchases into more longer-term to guarantee security supply. And again, that flies in the face of the energy transition. So that, unfortunately, is one of the by-products of this situation.
Roger [00:11:23] And when we talk about how long this is going to go on for, how long do you think it will take for the European market to become self-sufficient again, i.e. have all these, you know, whether it be fossil fuels, renewables, existing or whatever, all coming together to basically say, okay, we are now no longer reliant on that specific import that we had before. What sort of time frame is that going to be?
Wayne [00:11:42] I think it could be anything up to at least two years. I mean, different countries have got different speeds of exiting Russian gas. We've seen the ban on oil already come into effect yesterday, they had an agreement, but with the gas market, they're never going to sanction the gas market and force Russia not to export to Europe because that would be economic suicide for Europe. So what we're going to see over these coming years now is an acceleration of that investment. So we're going to need to invest a lot more in these old, some of these older facilities to bring them back up to speed, like the UK government talking about reviving Rough, which was actually decommissioned in 2017, that would cost money. If you want to extend the life of nuclear, that costs money, if you want to build interconnection, that costs money. So everything we're talking about costs money, and that investment needs to see longer-term contracts being signed to encourage further investment in, as we said, previously dwindling fossil fuels.
Roger [00:12:38] So overall, you know, as you say, we have sort of, maybe the calm before another storm, or it may just be the calm when things have already settled down. But for investors looking at Europe, there's effectively there's an overhanging risk premium or a risk out there, which means that, you know, it could flare up any time. And we don't really have that much control over it.
Wayne [00:12:55] We certainly don't, and that's the sad thing. We have no control over this. And like I said, while this invasion continues, this risk premium will have to remain because as we keep saying, nothing is off the table at the moment. And we're seeing that on a week-by-week basis, month by month, things we never thought would happen are starting to happen or have been happening. So I definitely would say these risk premiums will remain in place until we see a cessation of hostilities.
Roger [00:13:21] And if you've got any questions about this episode, financial markets or the economy, please put them in the comments section or send them to email@example.com.