IMPROVED INFLATION WELCOMED BY MARKETS BUT IT IS TOO EARLY TO CLAIM IT IS UNDER CONTROL

IMPROVED INFLATION WELCOMED BY MARKETS BUT IT IS TOO EARLY TO CLAIM IT IS UNDER CONTROL

This week’s election results and inflation update looked very similar for Rishi Sunak’s government – better than expected, but far from good. The Conservatives defied predictions of a loss of all three constituencies. However, victory in Boris Johnson’s former constituency needs to be seen in context of a majority of 7,000 reduced to just 495. Similarly, the sharp decline in headline inflation cheered markets as this was much better than forecast. But core inflation remains very sticky, as the drop in CPI was driven by the decline in the cost of petrol and diesel.

Former Bank of England Governor Mervyn King warned that further rate hikes risk triggering recession, but the bank is caught in the middle of conflicting signals. UK consumer sentiment has deteriorated sharply as higher interest rates squeeze household budgets, but consumer spending was resilient in June. Inflation remains far from target and without clear evidence of a slowdown the Bank of England is highly likely to keep hiking. Markets see rates peaking below 6%, but, much like the government’s hopes for re-election, this leaves a lot of room for disappointment.

UK: POSITIVE INFLATION UPDATE LIFTS MARKETS

Financial markets received a boost as UK inflation fell faster than expected. The Consumer Prices Index slowed from 8.7% to 7.9%, the biggest improvement in two years, as petrol and diesel prices fell. Core inflation also slowed, but this was less dramatic as inflation excluding volatile energy and food prices fell from 7.1% to 6.9%. Food inflation appears to have passed its peak. Research agency Kantar reported food inflation has fallen for four months in a row to 14.9% down from 17.5% in March.

The positive news on inflation helped lift government bonds. Slowing inflation means markets now see rates peaking below 6% and the yield on benchmark 10-year gilts fell to 4.2%, down from 4.7% two weeks ago. UK equities also rallied strongly led by housebuilders and property developers. A lower peak for interest rates should reduce the cost of mortgage borrowing, reduce the debt burden for commercial landlords and support higher valuations. Sterling gave up some of its recent gains against the dollar.

CHINA: SLOWDOWN ADDS TO SPECULATION OF ADDITIONAL STIMULUS

China’s economic growth slowed dramatically in the second quarter as GDP increased by 0.8%. This is a big drop compared to the 2.2% in the first three months of the year. China’s exports continue to lag due to lower demand from developed economies. Domestic demand is also falling. June retail sales were just 3.1% higher than last year when Covid restrictions were in place. The drop in retail spending weighed on luxury goods brands like Richemont, LVMH and Hermes.

China’s unemployment rate remained unchanged at 5.2%, but unemployment amongst 16 to 24-year olds (including many graduates) is running above 20%. Meanwhile the severe problems facing China’s property sector have not disappeared as troubled developer Evergrande revealed losses of $81bn since 2021. China is on track to meet its target of 5% growth in 2023. However, the spluttering economy has led to speculation that additional stimulus is on the way.

COMMODITIES: RUSSIAN AGRESSION STILL HAS POTENTIAL TO DRIVE PRICES

The International Energy Agency warned that Europe could still face an energy crisis this winter. The price of gas has fallen massively since its peak last August, however, the IEA said as Russia still accounts for around 10% of Europe’s imports.

It said a cold winter combined with difficulty securing supplies of liquified natural gas could see gas prices spike if Russia cut its exports entirely.

Russia’s reliability as a trading partner has been further diminished after it withdrew from an agreement which allowed Ukraine to export wheat through the Black Sea. Following its withdrawal from the agreement, Russia’s military has attacked agricultural and export infrastructure in Ukraine, including the key port of Odesa. This has helped drive up the price of wheat by around 13% this week and sunflower oil has risen more than 5% – although these prices remain far below the levels seen in 2022.