European Markets with Peter Schaffrik: May 2023 - Transcript

Peter Schaffrik:

Welcome back to European Markets. My name is Peter Schaffrik, and today is the 31st of May, 2023. Markets have been driven by fear of inflation once again, and of late, bond yields have increased again. So I think it's just appropriate to revisit the topic of inflation, the dynamics, and what's in store going forward.

First of all, let's just talk about headline inflation for a moment. What we've seen is that in the Euro area, and lately even in the UK, headline inflation has fallen. But the dynamics are very different in various countries, as the pass-through of wholesale energy prices into the retail sector is quite different from country to country. The left-hand chart shows Spain, the right-hand chart shows the UK. And the difference couldn't be starker. In Spain, wholesale prices are almost immediately being transmitted into the retail price sector, and you can see that headline inflation has fallen very sharply, from 10.7% in the peak to 3.8 at the moment. So nearly a 7% drop.

In the UK, on the other hand, the regulator has regulated prices and they're only slowly starting to fall now. And we had a peak of 11.1% and have seen a mere 2.5% drop so far. So a very strong difference and the market has taken note. However, as the next chart shows, it's just a question of timing. Headline inflation will fall almost across any country in the Euro area at different speeds. And in the UK, what you're seeing, or what you will see rather, is that headline inflation and the contribution of energy prices will drop sharply in the month to come. Secondly, however, we also have to talk about core inflation, mainly because central banks have mentioned that core inflation and the drop of core inflation is imperative. And so far, core inflation has not followed headline inflation yet.

However, what we've seen in the latest number for the Euro area is that core inflation seems to just about starting to decline. Again, we think that it's almost certain that it will, with a time delay. Yet again, in the UK the trend is slightly different and the latest core inflation number was higher. But also here, we think it's just a question of time until core inflation will start to decelerate.

Where does this leave us? First of all, the word pause is making the rounds as far as central banks are concerned. The [inaudible 00:02:54] announced one, the market is strongly assuming that the ECB will pause after another one, possibly two interest rate hikes. We think two is more plausible. And the only odd one out is the Bank of England where the market has over the last couple of weeks pushed the implied peak rate significantly higher, now to north of 5.5%. That's higher than where it would be, for the fed. We think this is unlikely, mainly because the inflation dynamics are not so different as the market would think.

Secondly, after the pause, we think it is very likely that the central banks across the board will stress that they will remain at the levels that they have reached for quite some time, in order to see what the impact on the economy is, in order to see whether inflation will come down, and whether inflation will come down sufficiently so that they are satisfied. And we think that this might be going against the grain in the market, which is assuming rate cuts somewhere in 2024, which we consider for the European markets as fairly unlikely.

So we think that for the time being, we're probably in an environment where inflation dynamics will start to shift, which will probably start to shift the mood and the narrative in the bond market a little bit, and we might be getting a little bit more of a positive environment for fixed income markets in particular. Does that mean we're in the all clear? We doubt it. I was mentioning earlier that the market's already implying rate cuts for 2024, and that rests on the assumption that inflation is going to fall back to the target somewhere in Q1, Q2 next year. And even though I've just explained why headline inflation will fall, I also think there are some sticky inflation elements in the economy, mainly stemming out of the very tight labor markets, that make it unlikely that we'll see inflation fall back to a level where the central banks will get the thumbs up and even start cutting interest rates. But we'll revisit that topic in a future edition. Thank you for watching.

Speaker 2:

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