Roger [00:00:00] With a global energy crisis spreading its wings, oil prices are edging higher. Having ignored high levels of consumer price inflation, bond yields are now tracking oil prices, which have historically been one of the key drivers for inflation expectations and yields. Is today's economic growth sufficient to withstand high energy prices? Well, that's today's Big Conversation.
Roger [00:00:22] Prior to 2000, higher energy prices, in particular crude oil, were generally a drag on the economy. Large moves are often a precursor to recession, driving the final nail in the coffin of an already weakened economy. But from 2003 to 2014, the impact of oil briefly had an inverted effect on the economy, even though a surge in oil prices in 2008 again rang the bell for financial markets. But for most of that period, higher oil prices led to increased capex within the industrial and energy complex, and it also helped boost job growth. The main driver was demand from China and her insatiable appetite for all commodities. Higher prices and cheap funding then help the development of less accessible reserves such as deep water and shale. For much of this period, higher oil prices therefore had a positive impact because the energy costs were offset by investments in jobs. The commodities bust of 2014 then began to shift the balance back to higher energy prices, becoming an economic drag rather than a benefit. Fossil fuels, in particular, have seen significant underinvestment over this period, resulting in fewer benefits along the industrial supply chain. Now there is a case being made today that higher commodity prices are reflecting a surge in demand, and not just a problem with supply chains. But if demand is really picking up, then higher commodity prices and higher yields could persist. If, however, current demand is actually weak, then the move in energy prices has the potential to push global economies back towards much lower growth and even recession. And that would have significant implications for inflation during recessionary periods, the level of inflation has always fallen. Now, that doesn't mean it goes into deflation, that's happened only once since 1970. But it does mean that some of the inflationary pressures are reduced, as you would expect when growth is being impacted. Therefore, what really matters for the inflationary debate is what's the base level during a period of higher inflation in the 1970s? We saw swings of between 7 and 10 percentage points, but the base level was around five percent. So far this year, the peak in CPI is close to the base level of that 1970s period. Based on some of the producer price measures, CPI could rise a lot further. But how strong is the current level of economic growth? Is demand surging, or is most of the impact just coming from those supply chain issues? So despite the reflation narrative, synchronised global growth never took place in early 2021. There was a rebound off those really low levels of 2020, but most of the strength in reflation assets was a mirage of bottlenecks, base effects and positioning, rather than true real growth. And this is why the narrative has now turned toward stagflation. But is today's growth even sufficient to sustain high levels of inflation? Simply put, if today's levels of supply were back at pre-pandemic levels, would there still be an inflationary problem as a result of an actual boost to demand? Well, the answer to that is no. In fact, we can see just how much slack there currently is in the global economy. Firstly, global demand for oil remains well below the pre-pandemic peak. The shortfall is not the result of a substitution effect with alternative energy sources. Demand has only just rebounded to the lows of the financial crisis. The global profitability of U.S. companies certainly looks like it's regained the pre-pandemic levels, but it's not yet regained the pre-pandemic trend, which had been marching higher for most of the previous 20 years. So what about actual levels of activity as denoted by imports and exports? Well, if we first look at the U.S., the picture looks relatively healthy. U.S. imports are getting close to pre-pandemic trend levels, though this is an absolute rather than inflation adjusted terms. Nonetheless, it looks like the U.S economy is getting back to decent shape, but it's a different story when we look at U.S. exports. Now we can see a significant shortfall. The growth story, if it can be called that, looks very much like an extremely U.S centric affair bolstered by the numerous fiscal and monetary packages. Basically, the rest of the global economy has not recovered or stimulated its way to a significant rebound in growth. U.S. exports to the EU have fallen off a cliff, reflecting an altogether less healthy scenario within the European Union. Now, the ECB has been talking about taper, but it's going to be extremely cautious at best, even when we look at some of the stronger data points. The two year comparisons show the shortfall far more clearly. U.S. imports are still well short of the growth that prevailed for most of the last decade. The weakness in global demand is even clearer when U.S. exports are viewed on a two year basis. Today's rebounds from last year's absolute bust levels are hiding a rebound that has failed to regain the pre-pandemic levels. Now, given all the discussions about stagflation, we should probably compare today's levels with the 1970s. Back in the 1970s, export saw incredible gyrations, but generally remained in positive territory. Yes, there was inflation, but there was also growth. The economy only stagnated for brief periods. Today, we don't have that growth to start with, and China has changed. Evergrande, the regulatory curbs on the tech sector, these are all part of a rebalancing and redistribution that's been going on for the last few years. China's new orders export components of the PMI has rolled over. And excluding the pandemic bust is back toward the 10 year lows. The weakness in China's export orders is also reflected in the weakness of the Korean equity market. Now, Korea is an economy that's heavily exposed to exports and supply chains whilst importing most of its energy requirements. The KOSPI 200 has broken down, and the chart looks like a topping formation. It's an index that led the reflation charge at the end of 2020, but has struggled since. Higher energy prices are hurting growth. In fact, across the board, we're seeing the risks of growth pick up. Now if that's the case, then it's unlikely that inflationary pressures can be sustained at high levels. The dollar continues to grind higher. The Yen has been weakening against it and is breaking a very long term resistance level on the logged chart. Upward pressure on the dollar is building. The Euro has also broken key support levels, and if U.S. bond yields also start to squeeze higher, then this will weigh on the outlook for growth. And if bond yields surge from here, they could create a VAR shock for risk assets. We've already seen some stunning moves across the UK bond curve. Yields on the US 10-Year are creating a key chart pattern that's also reflected in the Long Bond ETF, the TLT, where y key support is approaching, but it's unlikely that a surge in yields would be long lived. The Fed would probably step in or risk assets would fall, and then this in turn would drive bond prices back up and yields back down. It would be a self-correcting mechanism, while higher yields would be the catalyst for lower yields. And within equities, an ongoing hedge for the energy crisis could be a relative long-on energy names vs. the broad based market. In Europe the ratio of the energy sector vs. the STOXX 600 looks like a reversal pattern that favours a breakout of those energy names. Many of the large cap energy names in Europe and the U.S have dividends in excess of four percent, making these stocks also very attractive to income investors as well. But perhaps the biggest conundrum is still that incredible divergence between bond yields and those measures of inflation. Yields remain close to their multi-decade lows, whilst measures of PPI, that's producer price inflation, in many countries are at multi-decade highs. Does this already indicate that investors think economies can't cope with those higher energy prices? Well in the next section I speak to David Rickard, Director of Rates Trading Solutions at the London Stock Exchange Group and formerly a rates derivatives trader for about 15 years about some of the reasons why traders have so far not chased the inflation narrative to push those bond yields to significantly higher levels.
Roger [00:07:48] It's easy to get caught up in the view that the bond market should be doing more to reflect the current surge in inflation. But for most bond market investors and traders, the investment framework has to start with the policymakers because of their direct intervention via activities such as quantitative easing.
David [00:08:02] Central banks, in particular, have been very vocal in stressing the transitory nature of inflation, if we look at a couple of those factors for a moment, for example energy prices, supply side bottlenecks and labour market tightness. These could actually turn out to be pretty short lived phenomena, and therefore the markets are reluctant to overreact to this. You know, they, they believe in the central bank framework that have been set over many years around keeping policy focussed on inflation in the long term. And central banks have, have come out recently in various reports, speeches, official meetings and confirmed that that continues to be their view. So traders and investors respect that, and they're looking ahead for inflation rather than in the past or today where inflation is printing. So that has led to a moderation, I think, in some of the response in the bond markets to current inflation readings.
Roger [00:09:02] If it was just about inflation, then bond yields should be significantly higher. There are, however, many inputs that investors will be watching, and it's often things like forward expectations of inflation, not actual spot inflation, which is the key driver of bond yields,
David [00:09:16] There's a wide range of factors that traders and investors alike will be looking at. But definitely, for example, 5 year, 5 year HICP swaps for European inflation European developments, 5 year, 5 year RPI swaps in the UK, 5 year, 5 year TIPS break evens in the US. Obviously the commodity prices, oil price, gas prices, natural gas, electricity, coal movements in equities will be closely watched in terms of growth dynamics. We are entering earnings season now as well, so you know there's some key data points there that people will look at to to get a read on activity levels because that's still a point of uncertainty. And then the shape of the yield curve, you know, how are we trading the short end versus the long end? You know, traders are very focussed on the central bank pricing at the shorter end of the curve with active trading and overnight interest rate swaps, for example in the UK around the MPC meeting date.
Roger [00:10:18] The shape of the yield curve is another key component, and that's the comparison of yields with different maturities, such as three months, 5 years and 10 years, et cetera. Now, many people will watch the 10 year part of the curve, especially in the U.S. But if policymakers are playing catch up, then the focus should really be on the shorter maturities
David [00:10:33] 1 year, 1 year, 2 year, 1 year, those forward points. If you look at the curve right now, they're still very low, particularly or completely flat when you look at Europe in particular. Almost nothing priced. Even the Bank of England, which appears to be the most hawkish of the central banks, and in the U.K., we seem to at the moment have the the sharpest reaction to inflation, there's still very little price for 2023 2024. And certainly that's also the case in the US, where even the FOMC recently will look at the dot plot released by the the FOMC committee it's still very modest in terms of rate hikes 1 year forward or 2 years forward. So I think those are the points of the curve that could really come under pressure if we start to see some material risks for inflation and stronger growth.
Roger [00:11:26] A further consideration for bond yields is not just whether they'll go up or down, but for how long. It may be that global economies can't stomach a significant rise in yields and therefore a move higher would actually be quite short lived.
David [00:11:37] There's probably a number of factors there, but I think we need to keep in mind where we are in the long term debt cycle and in particular there's a huge amount of debt in the economy globally, and central banks are keenly aware of that. So I think they will, they would tend to err on the side of allowing a bit more inflation rather than raising rates too soon and the market knows this. And that's partly the reason I'm sure that's driving equity prices higher and higher. Is this lower for longer relaxed attitude or approach to inflation with the backdrop of significant debt levels globally, so will we see significant rate rises? It's a little bit chicken and egg, you know that the central banks know that asset markets now would be very reactive to any sign of aggressive tightening or frontloading hikes, and could actually cause a deflationary outcome in the curve because again, which goes back to the transitory question of inflation, if this is a transitory period, then significantly tightening now could actually have a deflationary negative impact of growth long term.
Roger [00:12:47] The bond market has been a conundrum for years. Yields have been historically low, and especially so today, considering those levels of inflation. And the framework has probably changed quite a lot over the last decade because of that policy intervention. Now there are clear risks for higher yields. But the market seems to know that higher yields could clobber risk assets. And that means that higher yields should be transitory in nature, even if inflation isn't. And if you've got any questions about this episode, the financial markets or the economy, please put them in the comments section or send them to TBC@Refinitiv dot com.
