Inflation dominates in 2022

Overstimulation of demand without the same pick-up in supply has driven inflation. In the UK, roughly only a third of the inflation is domestically generated. Parker said: “Supply chain disruption is responsible for much of the temporary inflation spikes. Central banks are concerned this inflation – imported from other parts of the globe – could then be seeded into domestic inflation expectations and pay growth and wage demands.”

Central banks anticipate that the short-term inflationary spikes from energy prices and commodities will quickly fall back. But Parker added: “What we’re hearing is that shortages remain across a broad range of industries, and consequently, these spikes might prove to be more semi-permanent than short term.” It is worth noting that while freight and gas prices have fallen back from peaks, they remain elevated from where they rose initially.

The headache this is causing authorities is that they don’t want to be too robust in tightening monetary policy because that could negatively affect economic activity. Parker said: “Equally, they don’t want the inflation spikes to be embedded within domestic economies, and throughout 2022 and into 2023, because they may require more sizeable increases in interest rates into 2023 and beyond.”

There are some sizeable rate increases already priced into the US and UK. Bloomberg predicts several interest rate hikes over the year, both in the UK and the US. “We’ve had two rate increases within the space of two meetings, so the pace of rate increases will be significant, and the speed of rate increases may slow as we approach the summer months in the UK,” said Parker.

“Whereas for the US, we could see an acceleration in rate increases, with the US interest rate overtaking that of the UK before the end of the year.”

But there are risks. The UK economy may slow in momentum, and consequently, that may prompt more caution from the Bank of England about pushing through further rate rises. “By the time we get to 1.25% in the UK, it will be a more finely balanced judgement regarding increases,” observed Parker. “Whereas in the US, we’re looking at 1.5% – 2% before the Federal Reserve starts reining back the pace of rate increases.” 

“We’ve had two rate increases within the space of two meetings, so the pace of rate increases will be significant, and the speed of rate increases may slow as we approach the summer months in the UK. Whereas for the US, we could see an acceleration in rate increases, with the US interest rate overtaking that of the UK before the end of the year”

Neil Parker, Market Strategist and Economist at Royal Bank of Scotland

The European economies lag behind the US and UK, and rate increases will be slower in the eurozone. “More importantly,” said Parker, “I think they may look at moving the deposit rate in the first instance, from the minus 0.5% that we see, and look to bring that closer to nought. For the eurozone, the terminal rate is probably not much above 1%. So there will be some sizeable interest rate differentials between the US, the UK and the eurozone.”

Parker pointed to some material downside revisions in the US and China, and some smaller revisions to the eurozone and the UK in terms of growth in 2022. He also predicted some modest upward revisions for Japan and a more significant upward revision to economic activity in India.

He said: “I’m not sure the risks associated with global economic growth in 2022 are fully factored. It could be far slower and could again be impacted by supply chain disruption and labour market shortages.”

Additionally, there could be some credit risks around China due to the property sector. Over the past couple of years, in both the UK and the US, companies have leveraged themselves more than they would normally to keep going. “That leverage could create some downside risks to growth and, therefore, slow the underlying recovery of the global economy,” says Parker.

Moreover, Parker believes inflation is doing significant damage to household incomes, particularly in the West. “Equally, for China, those risks around a potential new credit crisis associated with both commercial and residential real estate could have a significantly detrimental effect on the Chinese economy. That’s one reason why we’ve already seen the People’s Bank of China try to loosen monetary policy, while virtually everybody else around the globe is tightening policy.”

Volatility will be the overriding theme for the foreign exchange markets throughout 2022. The pound’s fragility to sustaining rallies against the US dollar has been apparent in recent weeks as doubts over rate hikes and growth have emerged. “The sterling/dollar is potentially under pressure, and the threats are asymmetrical to the downside – whereas, on the topside, it would take a break back above 140 to really instill confidence that sterling is heading higher,” said Parker. “And there’s still that level around 142 and a half, which has proved to be a significant psychological and technical blocker for any further drives higher. So I don’t see there being much upside in sterling/dollar beyond the 138 regions.

“In the longer term, Europe could benefit from a relatively faster pace of monetary tightening against expectations. And consequently, we could see the euro strengthening into the end of 2022, and the first half of 2023.”

Parker highlighted the relatively impressive increase in 10-year yields from the UK, the US and Euroland. “We’ve seen a sizable rally in some of these yields, but you’ve only got to look back to where they’ve rallied from. Consequently, although the rally yields have been impressive, it hasn’t done that much to persuade me and other market participants that we’re in a bear market as far as government bonds are concerned.”

If there are challenges to growth and inflation drops away or there are no signs of second-round effects, we might see government bond markets come under pressure. Parker said: “If there is a drop back in risk appetite, I would expect treasuries, guilds and bunds to be a major beneficiary in terms where these yields will head.”

However, Parker ended on a note of caution. “Over the medium term – the next two to three years – the risks of recession are far higher in the major Western developed economies than have been priced. The reason for that is the leverage levels accumulated from both a corporate and a sovereign perspective. There are some significant risks that, if yields stay this high or rise further, the funding costs associated with this will damage any prospects of both state- or private-side investment to improve productivity.”

This article is a write up of a webinar we hosted with Neil Parker on 10th February 2022. You can watch a recording of the full event here.