Blue Bay AM: Gas panic... Putin to the rescue?

October 8, 2021

BlueBay Asset Management CIO Mark Dowding has issued his latest market commentary, this week focussing on UK stagflation concerns and the energy crisis in Europe. 

A further jump in gas prices added to inflation concerns over the past week, with the UK caught in the eye of the storm.

UK gas printed a new record of 400p per therm in the wholesale market (up from 60p at the start of 2021), before comments from Vladimir Putin helped to restore some calm. As investors digested the impact of energy prices on CPI, breakeven rates on 10-year inflation-linked Gilts rose above 4% ­– in a clear sign that inflation expectations are becoming de-anchored from the BoE inflation target.

Supply remains tight

Supply remains tight, even before the colder winter season of peak demand gets underway, and European policymakers are starting to wake up to the reality that green policies have left the continent vulnerable to Russian imports. This may lead to increased investment in renewables and nuclear in the years to come, but this is of little benefit in the shorter term.

For now, it seems that the continent will need to play nice to Russia and a country such as the UK will have to accept that it is in no position to call the shots.

Equated in the context of oil prices, the current level of wholesale gas prices in Europe are the equivalent of close to $ 250 per barrel.

Picture in US is different

The picture in the US is very different. Thanks to the country being energy self-sufficient, gas prices have moved by a much smaller amount. However, with US inflation already well above the Fed target, it seems that elevated US prices are also set to persist for longer than currently forecast.

With upward pressure on wages in the face of strong labour demand, this is also leading to a change of narrative within the Fed, as evidenced at the last FOMC meeting. The pandemic may have lowered labour participation on a more lasting basis amongst older and female workers, in part linked to a reassessment of life priorities.

Consequently, the NAIRU may be higher than it was assumed to be before COVID-19, with the Phillips curve having shifted somewhat. We continue to look for robust employment gains in the next few months, but it will be interesting to keep at least one eye on wages, to see if any tightness leads to wages trending stronger.

From this point of view, higher inflation may come at the expense of slower growth in Europe and the UK, though it may be a function of strong growth and robust demand in the US. We see this divergence supporting the outlook for the dollar, while yields in the eurozone should probably be better underprinned, even as we continue to look for US Treasury yields to resume their rise.

Prospect of stagflation

In the UK, the prospect of stagflation is making a recession later in 2022 a much more material possibility and this risk is being compounded by government policies. The Tory administration is trying to talk up wages in sectors where there are insufficient workers, but this could end up feeding the inflation dynamic and causing the BoE to hike rates, increasing mortgage costs.

To compound this, there is the prospect of fiscal tightening on top of monetary tightening, when a more sensible policy would call for an easier fiscal stance to support economic growth. However, it seems this government is oblivious to reason and thus quite happy to head towards a stagflationary outcome.

The tragedy seems to be the fact that instead of achieving any ‘levelling up’ of incomes, all that will result is a ‘levelling down’ in real terms. Delivering increased equality may be an attractive policy choice, but if this is the goal, this could be better achieved by cutting taxes on lower income groups and raising them for those who are better off.

As with its handling of the post-Brexit transition, it strikes us that the UK is likely to be staring at many problems largely of its own making – even if Boris Johnson doesn’t seem to want to accept any responsibility or accountability for things when they go wrong. Instead of invoking Margaret Thatcher, it seems the actions of this prime minister are more likely to see the Iron Lady turning in her grave!

Certainly, the UK is an interesting test case and policymakers elsewhere are looking on with a mix of alarm and curiosity. Elsewhere in the eurozone, policies to subsidise consumers and protect them from higher gas prices have been fairly widespread. The recovery from the pandemic continues, though supply disruptions and slowing growth from China could impact industrial output.

We expect PEPP to end in March, but for other asset purchases to pick up around the same time. With inflation expectations more firmly anchored, we see more scope for accommodative monetary policy in the region.

Risk assets

Risk assets came under pressure at the start of the week, before stabilising. Credit traded in sympathy with equities, though generally speaking volatility in spreads at a macro level remains very muted.

In Asia, further weakness in Chinese real estate saw a number of issuers under pressure, with Fantasia failing to pay a bond redemption and prices on this security dropping from par to around 20 cents on the dollar in a matter of hours. Chinese markets were closed for Golden Week holidays and although sentiment remains fragile, we share the widely held view that policymakers in Beijing are unlikely to allow individual issuer failures to become a globally systemic macro dynamic. We remain constructive on Chinese rates with policy set to be eased, even as it is tightened elsewhere.

However, we would also highlight the importance of understanding bond structures when investing in countries like China, with those participating in issues constituting a Cayman-based shell structure likely to learn that they have no claim over any assets that can be chased in any court of law.

FX

In FX markets, the dollar has continued to edge stronger and as we survey trends in the energy markets, we are inclined to favour exporters over importers, as terms of trade undergo some interesting changes. For example, countries like Colombia, Mexico and Norway all export oil, whereas India and Turkey are oil importers.

We retain a bearish view on the pound on the belief that growth is set to slow. More generally, we feel that rising macro volatility, as QE policies run their course, can lead to increased divergence between countries and so further opportunities on a cross-market basis.

Looking ahead

US payrolls will likely dominate the headlines in the next day or two. But looking beyond this, we expect attention will quickly move back to CPI data and the broad-based inflation theme. It seems unlikely that we will witness much to push the Fed from its planned course of commencing the taper after its November meeting.

As for recent negotiations surrounding the debt ceiling, we view this as more of a game of political point-scoring than anything more pertinent. Some progress towards a compromise on a USD2 trillion Democrat package of spending and tax rises seems to be coming closer into view and the debate over whether Powell will be retained as Fed Chair is also likely to reach its climax in the next few weeks.

With plenty going on, it is perhaps noticeable that Covid is starting to drop out of the headlines and the broader market narrative. Although the pandemic is far from over, we seem to be living with the virus and, notwithstanding elevated numbers of infections, it remains encouraging to see hospitalisations trending lower over time.

All this may suggest reasons to be optimistic, but from a financial market perspective, the looming spectre of taper may hang like a shadow until this is put behind us. The gas panic over rising prices is another reason for concern, though hopefully we can learn to love Vlad the Bad and all play nicely together. If only he could send the UK some tanker drivers, we would all find ourselves saying a grateful ‘spasibo’.