18 May 2022
Expert Q&A: The deeper effects of inflation
Neil Parker, FX Market Strategist at NatWest, shares his thoughts on markets and the economy in an inflationary environment.
Neil Parker, FX Market Strategist at NatWest, has been watching markets for almost 30 years. What he is witnessing currently is, he says, without precedent. “I have not experienced economic uncertainty like we are experiencing now. It is scary for some businesses because we have been through some major crises over the past 25 – 30 years, for most of which I have been in the markets.”
The main driver of this turmoil is inflation, leading to a cost-of-living crisis and an increasing likelihood of recession, as consumer confidence crumbles and discretionary spending disappears. While the crisis in Ukraine has made a bad situation worse, Parker says that before it, the world’s major central banks had belatedly woken up to the fact that supply chain disruptions were a long-term issue. This means inflation is set to stay, requiring them to rip up forecasts. “They suddenly got more hawkish and aggressive with the amount of monetary tightening they were prepared to sanction,” he says.
Thus, markets now expect an extended period of high inflation and rising interest rates. For Parker – and some experts at the Bank of England (BoE) – a recession induced by inflation is inevitable. While in early May the BoE simultaneously raised the base rate to 1% and warned of recession, the continuation of poor economic data, he believes, will curtail central bankers’ desire to keep raising rates. But markets don’t agree with his assessment on recession and are pricing in more rate hikes.
Here, Parker answers some questions on what the future may have in store.
What are your thoughts on the economy and markets for 2022 and beyond?
“Central banks will move closer to our expectations on interest rates, rather than adopt a dogmatic approach to monetary policy. The second half of this year and into 2023 could be very interesting from a market point of view, because you could see a lot of turmoil and a lot of flux around interest rate expectations and risk appetites.
“Psychology plays a part and, as individuals, we are now conditioned to very low rates. Anything that moves the dial materially away from that low base is a cause for concern. The pandemic prompted the average householder to become more leveraged than previously. This is particularly noteworthy with the middle-income bracket that traditionally had a lot of discretionary spending power. They’re being squeezed from all sides, with higher taxes, higher energy bills, higher costs to fill up their cars and higher food prices. It is staples where the inflation effect is feeding through. Any interest rate increase will magnify the impact.
“Towards the end of 2022, we’ll see yields fall consistently to levels more in keeping with macro risks”
Neil Parker, FX Market Strategist, NatWest
“I fear markets have had a memory wipe, not just about the pandemic, but the financial crisis. Markets aren’t learning the lesson that risk is greater than they price for. Why aren’t we recognising how deep the impact will be on real disposable incomes? It is like we assume there is this stockpile of cash we can just deploy. The risk is far worse than the financial crisis. That was brought about by excess from consumers and businesses, this one has come from central banks not weaning us off cheap credit and now suggesting we need to go cold turkey. That will not be pretty.”
Where do you see inflation and interest rates heading?
“In the UK we’re looking at consumer price inflation peaking in the next few months, at around 9.5% or 10%. Then it will head lower. The BoE expects the main reduction in inflationary pressures to come in two to three years’ time. But I think the headline rate of inflation will reduce by around 2% to 2.5% by the end of 2022, to about 7.5%.
“Market pricing for interest rates for the UK, US and Euroland is wrong. Central banks’ appetites to tighten monetary policy will disappear when economies suffer. I don’t think UK interest rates will climb above 1.75% and could start to drop by the end of 2022. It’s dependent on the macroeconomic outlook. Will there be enough evidence to support a case for further rate rises? The BoE won’t be blind to the squeeze on consumers, particularly with tighter fiscal policy. At the same time, the BoE is wedded to using interest rates to tackle second-round inflation. As far as the UK economy is concerned, they’re worried about the pass-on through wages and businesses building back margin into pricing.”
How is this uncertainty affecting markets, and what does data tell us about confidence?
“We are initially going to see higher yields. Inflation has driven yields higher than they ought to be if we were just basing it on interest rates. But interest rate expectations have risen sharply, so we haven’t reached a peak in UK yields. They could move up by 25 basis points, with markets not accepting recession risks. Five-year gilts could go north of 2.00%, 10-year to 2.25% and 30-year as high as 2.40%. Then markets will get a shock and reverse. From a risk perspective, money flows into bond markets when we’re nervous. Equity values are already inflated and there is the underlying macroeconomic risk. Towards the end of 2022, we’ll see yields fall consistently to levels more in keeping with macro risks. Five, 10 and 30-year gilts will be down at least 20 to 30 basis points from the peak. The Fed and ECB [European Central Bank] will face the same issue, with yield curves pricing in too much from a monetary tightening perspective and pricing it to persist for far too long.”
Is there much that investors can do to protect themselves?
“To use an analogy from an old boss: ‘Make sure you invest in sun cream and umbrellas.’ The ideology is sound for most markets. If you are diversified, you won’t get all the upsides of anything, but you also won’t be exposed to all the downsides. As we approach a downturn, it will boost prices for bonds, especially government bonds and lower yields. At the same time, it will have a negative effect on equities and other risky assets. I don’t know where you go in that situation. You invest in precious metals or land at your peril over the short term, because they tend to be volatile and you don’t know what’s coming. Other than battening down the hatches and trying to wait out the storm, I don’t think there’s much that can mitigate the short-term elevated inflation pressures over a short one- to two-year horizon.”
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