Last week’s news was dominated by inflation. UK data showed that the CPI measure of inflation rose to 3.2%, with RPI inflation at 4.8%. The implication of rising prices is currently the number one concern of clients and this is understandable as inflation erodes the real purchasing power of fixed cashflows.
One area that has got a lot of attention is the price of gas and electricity in the UK. There were several factors at play here. First, a fire at a plant in Kent caused damage to the interconnector between England and France. These cables bring in electricity from France when demand in Britain peaks. National Grid estimates that half of the 2-gigawatt capacity will be offline until March next year – so there is no quick fix. Second, this is at a time of high global gas prices. And that’s not all: a shortage of summer winds has reduced electricity production from UK’s wind farms and there have been a series of nuclear power plant outages that have compounded the situation.
So, what are the consequences? Well, it means more generation from coal powered stations, which is not ideal. For the consumer we will see higher energy bills soon – as caps are removed and prices reflect the new reality. For businesses, it means lower profits unless costs can be passed on – which will erode consumers’ spending. But it will also mean businesses reduce output or even close. Last week brought news that two fertiliser plants were stopping production due to higher energy costs and steel makers warned that production was already being pared back. And there are other knock-on effects: I was unaware that fertiliser production is the main source of carbon dioxide, used extensively in the food industry. This is not a uniquely UK phenomenon – but we are at the sharp end.
Will these events spur an acceleration to renewable energy? The EU thinks so, noting that it is fossil gas prices that have rocketed and that the costs of renewable generation have remained relatively stable. I think we need a much greater debate on how societies transition away from reliance on fossil fuels. The UK government recently addressed one long-term problem, social care, through a National Insurance hike. I say addressed – it is an unfair fudge that will not work in my opinion. An even greater challenge, however, is how to manage the net zero commitments being made. Let’s face it, £50bn is a lot of money. That is the cost that the Government’s Climate Change Committee estimates will arise in 2030. To be clear, this is an annual cost for twenty years (2030-2050). This will dwarf Covid and social care expenditures.
Cash and government bonds
Retail sales data out in the UK and US painted different pictures last week. In the UK retail sales fell again in August, down 0.9% in contrast to consensus expectations of a 0.5% gain – although retail sales are nearly 5% above pre-pandemic levels. Online sales remain well above pre-pandemic norms with the proportion of online sales at 28% in August compared to around 20% pre-pandemic.
In contrast US nominal sales grew 0.7% in August. A broad range of data has suggested that US activity growth weakened over the summer, reflected in the July sales data being revised down. The most recent data, however, indicates a bit of a bounce back. Like the UK, the level of US retail sales remains well above pre-pandemic levels.
Global government bond markets were weak. UK 10-year yields approached 0.85% and there were also moves higher in the US (1.37%) and Germany (-0.28%). Real yields retreated in most markets but there was some dispersion in implied inflation across markets: higher in the UK and lower in the US. The sell-off in markets took five-year UK gilt yields back to pre-Covid levels, as investors fretted about the Bank of England’s response to the latest inflation surprise. In cash markets one-year rates hit a 12-month high.
Demand remained strong for investment grade credit. In sterling markets, spreads nudged down to a new one-year low. Issuance remained strong but was well received. In high yield, markets spreads were broadly unchanged, with indices off their highs due to the retreat in government bonds. The situation of Evergrande continued to deteriorate, with a follow through to other areas of emerging market debt.
Returning to inflation – I am still looking for a pull back in 2022, but the base level of prices will be higher than expected. For those looking for comfort on the inflation front, have a look at iron ore prices: down a third in two months. China is slowing and this will impact global inflation.
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