The week ahead: Inflation watch

As the UK is plunged into mourning the late Queen Elizabeth II, the show must go on when it comes to financial markets. The death of the Queen is relevant for financial markets for a few reasons. Firstly, the UK will have a bank holiday next Monday 19th September, when the Queen’s funeral will take place. Secondly, the Bank of England has postponed this week’s rate decision, which will now take place on Thursday 22/9, and lastly, the timing of the bank holiday means that the UK could see a technical recession, as the UK economy rapidly weakens, with one less day of productivity likely to show through in the Q3 data. However, as we start a new week, risk sentiment is upbeat. This recovery in risky assets is starting to look like a market theme. Either markets are becoming less rate sensitive, or the traders truly believe that a Fed pivot is a possibility, even though they have remained hawkish.  The question right now is whether this rally is sustainable, and will this week’s key economic releases cause an abrupt end to the upbeat tone to global financial markets?

Can Truss save the UK economy from its woes?  

The big news on Monday was that the UK economy flat lined in the three months to July, with growth registering 0%, after a 0.3% increase in the three months to April. This lack of momentum was put down to surging prices that have been restricting consumption. The UK economy contracted by 0.6% in June, which was partly down to the two extra bank holidays linked to the Queen’s Jubilee celebrations, while the rebound in July was less than expected, at only 0.2%. Thus, economists are likely to revise down their September growth forecasts due to next week’s special bank holiday. The disappointing rebound in growth in July, suggests that the lack of momentum has already put the UK in recession. However, if UK economic growth is confirmed to have plunged in Q3, there are some who argue that the UK’s £150bn plan to ease the cost-of-living crisis and freeze energy bills, will support demand in the final months of the year, thus today’s data has not been met with gloom in UK asset markets. The FTSE 100 is up some 1.5% today, and sterling is also higher by 0.79% at the start of the week and is the best-performing currency in the G10. While most of this increase is down to an improvement in global risk sentiment and a broad-based decline in the USD, it is also down to an improving domestic outlook, which is why the FTSE 250 is also higher, and why UK 10-year bond yields are also down by nearly 3 basis points. The boost to the FTSE 100 is broad-based, but it is led by retailers, including Tesco and Kingfisher, with house builders also higher. We think that there could be further upside for UK retailers in the coming weeks, as they are effectively bailed out by the government’s cost of living package, which will free up household expenditure now that energy bills are frozen for two years. A longer-term theme that is also starting to impact markets is that the government’s energy plan will improve the outlook for inflation and bring forward the peak in UK inflation. However, we still don’t know the details of the £150bn package as normal parliamentary activities have been paused considering the Queen’s death and the ascension of the King to the throne.

GBP outlook: we remain wary in the long term, although recovery is possible in the short term

Overall, although GBP/USD has broken the $1.17 level today, we believe that this is driven by an over-sold pound, and a general bout of dollar weakness as market sentiment improves. Our long-term outlook for the pound remains weak, as massive borrowing to fund the £150bn energy bailout, means that the pound will need to devalue to ensure that the UK can attract buyers for its extra debt issuance. However, in the short term, the pound may benefit from a weaker dollar, and we can’t rule out a strong recovery back to $1.20. This may also be helped by a wave of growth upgrades for the UK economy as economists digest the government’s latest support package for householders. However, the biggest short-term driver of pound strength this week could be the US inflation report. Global inflation numbers are released on Tuesday, the market expects US headline inflation to fall by 0.1% last month, with the annual rate retreating to 8.1% from 8.5% in July. This looks good on paper, however, at this point in the economic cycle, we are focussing on the monthly inflation figures, and right now these suggest that even headline inflation is falling slowly. While US petrol prices have fallen sharply for the last two months, we think it will take more than a decline in headline inflation for the Fed to shift from its hawkish stance. Instead, we believe that the focus this week should be on core inflation. This looks less positive for the US, with economists expecting the core inflation rate in the US to rise by 0.3% on the month, and for the annual rate to rise to 6% from 5.9%. This suggests that underlying inflation in the US is still moving in the wrong direction, largely led by soaring rental costs. Thus, until they show signs of slowing, then the Fed will need to maintain is aggressive pace of rate hikes if it wants to bring inflation under control.

UK price pressures continue to build, but not for long

In the UK, inflation is expected to rise on both a headline and core basis. The core inflation rate is expected to rise to 6.3% annually, while headline inflation is expected to rise by 0.6%, an unacceptably high monthly level. However, the UK’s government’s plan to freeze energy prices will have a huge impact on inflation, with some economists now expecting inflation to peak at 11.5% in November, negating recent forecasts that expected UK price growth to peak at nearly 20% next year. We expect the BOE’s forecasts to be adjusted to reflect this, although we will need to wait for the November Inflation Report to confirm this. Of course, this support package could also stimulate some parts of the economy, thus inflation may take longer to cool. However, we think that the market will consider the long-term implications of this energy support package next week, after the period of mourning for Queen Elizabeth II is over.

To conclude

Thus, as the UK focuses on domestic matters, we look to global inflation data to see how this will impact risk sentiment. If we see strong core inflation in the US, we doubt that stock markets can continue to hold up, with the focus returning to the Fed’s rate hiking cycle and the risk to corporate earnings, which we will talk more about next week.