Market Commentary 16th September 2022
For those that don’t know, I am the Chief Investment Officer at IPS Capital. Each week I highlight few things that have come across my desk that I think are interesting and investment related. We always welcome dialogue so if you have any questions we’ll be happy to answer them here too.
Will we all freeze this winter?
For those that worry about this, some comfort came this week from Pierre Andurand, a long-standing (and successful) energy futures trader. European natural gas was responsible for 30% of European demand in 2021. Half of that has already been replaced by liquid natural gas imports from elsewhere. This means we need to cut demand by 15% overall to balance the market. Industry (via a mix of closures and switching to oil) is already beating this target. Households therefore need to deliver around a 10% overall reduction in demand for power generation and residential heating.
On Pierre’s numbers this is equivalent to turning our thermostats down from 22 degrees to 19 for the winter. We may need an extra layer of clothing indoors but I feel like this is doable? That said, I do have a couple of caveats. First, I live in an old house. Do we even have a thermostat? My wife and I both live in fear that every time we play with the central heating we may bring the whole lot crashing down. We may just have to try and turn off some radiators. Second, this all depends on how cold this winter is. If there was ever a moment for global warming to step up and deliver a mild winter to Europe, now is the time.
UK Inflation and the energy cap
A couple of weeks ago the new government announced the energy price cap for UK households (the cap for companies has yet to be set). As the chart below shows, the impact of this was to cut average expected UK RPI inflation over the next 2 years from 7.8% per annum in mid-August to 5.4% per annum today (CPI is normally around 1% lower).
This is quite a stunning fall. Part of the reason for going for the cap (rather than just sending out furlough style payments as we did in the pandemic) is that capping energy brings headline inflation down. This reduces the risk of wages chasing inflation higher and creating a new bout of inflation.
It is also worth noting that this is the smarter option for the tax-payer. 25% of the UK’s debt payments are done via index-linked gilts, where the coupon paid to investors is explicitly linked to RPI inflation. Bringing down inflation by 2.4% over the next 2 years (as the energy cap looks to have done) should mean saving almost £30bn on index-linked gilt payments.
The market for average RPI inflation over the next 2 years in the UK since mid-August
But what about US inflation?
I have tried to give some reassurance on how things are going in Europe, I’m afraid there wasn’t much good news from the US this week. The big (nasty) surprise was Tuesday’s US inflation number. While we still lean toward inflation drifting slowly down from here, there was little comfort on this from the September inflation report. Core inflation remains strong.
A large part of core is housing. While the housing market is definitely slowing down (mortgage rates have more than doubled in the US) this works with a lag and the inflation measure used in the inflation report (Owners’ Equivalent Rent or OER) itself has some lengthy (6 month or more) lags to where the property market is today. As an example, the chart below shows OER compared to a US rental market index. While the live data we see shows that this gap is now finally closing, the lags mean OER will not be falling any time soon. The nervousness we saw this week about where the peak for interest rates might be will be in place for the next few months at the very least. It will be hard for equities to rally with this cloud hanging over them.
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.