Rwanda looking attractive compared to the UK, come January

August 12, 2022

As energy bills spiral, the African sunshine is suddenly sounding a lot more appealing than a freezing winter here.

This week’s relatively benign July US CPI report helped to feed hopes that inflation is peaking and that this may herald a pivot in Fed policy in the coming months, thus supporting the backdrop for risk assets. However, headline inflation remains at 8.5%, with core prices at 5.9%.

In our estimation, core CPI is unlikely to fall much below 5% by the end of the year and inflation may only return to levels where the FOMC can feel more comfortable with the outlook towards the end of 2023. Therefore, we believe that it remains premature to be looking for rate cuts too early next year.

With the latest payroll report confirming that the US economy remains in good shape, for the time being, we think that some market participants have been wanting to assume a recession next year. In the absence of evidence to support this thesis, the view seems largely based on the notion that this should be the natural state of things in the wake of an inversion of the yield curve during 2022.

Consequently, we continue to look for 10-year yields to rise above 3% in the coming months and maintain a short duration stance with respect to 10-year Treasuries and December 2023 Eurodollar contracts.

We will see another set of payrolls and CPI data before the September FOMC and, at the moment, it appears that the odds between a 50bp and a 75bp hike are pretty finely balanced. With this picture unlikely to be resolved in the next couple of weeks, it is possible that rates volatility is subdued compared to the elevated volatility conditions that have characterised the past several weeks.

From this perspective, this backdrop may help equities and credit spreads make incremental gains at a time when investor positioning has appeared to have been overly cautious. Yet, with financial conditions continuing to ease, this may cause discomfort among some at the Fed who may be more nervous that this could offset policy actions taken to date. Therefore, we expect relatively hawkish Fed-speak to warn against this, and thus serve to contain price action.

Having run with a moderately long bias in risk assets over the past couple of months, this means that we are inclined to reduce exposure and add hedges on further strength from here, if spreads continue to rally. Conversely, we would look to realise gains on hedges were we to see renewed weakness.

More generally speaking, we think that if we witness a couple of weeks of mid-summer calm, then we should use this opportunity to position portfolios in anticipation of a return to more volatile conditions once everyone is ‘back to school’ at the start of September.

Newsflow in Europe has been relatively quiet during the past week, with much of the focus on roasting summer temperatures. However, with the drought adding to the energy crisis by impacting hydro generation, so gas price pressure has shown little sign of abating.

In the UK, policymakers have warned of rolling power cuts for both domestic and business users after Christmas and much may hinge on the type of weather this winter decides to bring. Many will be hoping for mild, wet and windy weather, such that wind energy can operate at maximum output. However, if conditions are dry, cold and calm, then it seems that gas reserves will quickly be depleted and, in the case of the UK (which intelligently decided to scrap any ability to store gas a few years ago), leaves them a hostage to fortune.

Of course, coal would offer a short-term solution, but with those in power unable to think more than a couple of days ahead, it would seem overly optimistic to think that there will have been much planning for contingencies being put in place in time.

Meanwhile, the focus across the continent has been on various fiscal support measures, aimed at shielding consumers from the worst of the cost-of-living shock associated with rising energy prices. Yet it seems that these steps are likely to only mitigate a looming recession, rather than avert this outcome from occurring.

Ostensibly speaking, this growth backdrop would typically see us express a more constructive view on government bonds yields in the European region. However, we think that eurozone inflation may remain elevated until the end of this year, lagging the turn in US inflation. Therefore, we think there will be little scope for the ECB to turn more dovish ahead of the end of 2022.

In the UK, we think that inflation divergence will be even more stark. To date, we have been surprised that the rise in UK inflation has only mirrored moves in the US and the eurozone. On a forward-looking basis, there should be material divergence, with even the Bank of England now projecting CPI to rise above 13% in October.

We suspect that UK inflation could remain very elevated over the year ahead, due to regulated price rises next April and businesses seeking to pass on rising production costs to consumers. The UK labour market remains tight as a result of Brexit and a depleted pool of labour; a weakened government may have little appetite to face down unions demanding outsized pay hikes in a number of key sectors. Stagflation may become entrenched, with the UK economy returning to the 1970s for a period of time.

Notwithstanding the recent BoE recession warnings, it seems that the true extent of what lies ahead has barely been digested in Westminster.

Indeed, contacts in the UK Civil Service have observed that in the past, no matter how incompetent politicians may have been, there were sufficient numbers of public servants who remained in role and ensured that the country could run OK. However, widespread job losses, disillusionment and a blank refusal to return to the office have all critically undermined the ability of the Civil Service to make sure the country keeps functioning on a day-to-day basis.

As we assess this and the prospective scenarios that may develop, we continue to retain a very bearish medium-term stance on Gilts, the pound and other UK assets.

Elsewhere, better news with respect to US CPI has continued to help lift assets in emerging markets (EM). Anecdotally, investors appear under-invested in EM and so market technicals appear constructive.

Liquidity has been thin across asset classes for the past several months. In light of this, spreads and individual bonds have been exposed to material underperformance when the market is one way around and everyone is looking to sell, in the absence of buyers. In the same way, when buyers return and there is an absence of sellers, so price action can be just as dramatic the other way around. However, we would continue to highlight the differentiation between EM countries where underlying fundamentals are supported, compared to those which have been badly exposed to rising food and energy prices.

In this context, we have maintained a constructive view on local rates in South Africa and Brazil, while highlighting vulnerabilities in Turkey, North Africa and other more frontier-type borrowers.

In FX, the US dollar has weakened in the wake of CPI. Based on our view that the US economy can outperform over the medium term, we are doubtful that we have seen the end to dollar strength just yet.

Meanwhile, we have been constructive with respect to the Australian dollar, whereas we have looked for weakness in a number of central and East European currencies versus the euro as countries in the region experienced an even more pronounced inflation overshoot than seen in the rest of the continent. For example, Czech inflation has risen to 17.5% in July and we think recent intervention to support the koruna is unlikely to be sustainable on an ongoing basis.

Looking ahead

Following the ‘big’ data releases in the form of US payrolls and CPI in the past week, it is tempting to think that markets could be quieter for the rest of August. With much of the northern hemisphere sizzling in the sun, it should not be too surprising if attention is diverted towards the beach for the time being.

Seasonally speaking, it may be a time when investors regroup their thoughts ahead of the push towards the end of the year, which kicks off with everyone back at their screens at the start of September.

Meanwhile, with the UK experiencing record temperatures this summer, it seems odd to be worrying about it getting cold in the months ahead. However, things could turn grim pretty quickly if the lights go off in January.

Speaking with those in government, it is concerning to hear ongoing discussions about trying to designate ‘warm places’, where citizens can take shelter within their local communities. Hopefully things won’t prove quite as bleak as they might sound.

Yet, one wonders whether instead of Priti Patel controversially paying for hotels and flights to Rwanda to relocate illegal immigrants entering the country, it would be better to offer a free holiday in the African sunshine to vulnerable older citizens seeking to keep warm this winter. After all, surely the government must have now realised that their policies on immigration are totally misguided and unworkable, plus the hotels and the flights have already been paid for.

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