The Bear and Trident

Short of friends, President Putin and China’s Xi Jinping recently met in Uzbekistan and while the former lauded the friendship between Russia and China, it is clear that the latter has ‘questions and concerns’ about the situation in Ukraine.

While Europe is re-pivoting away from Russian oil and gas and trying to cut energy usage, Russia is re-aligning to China. Russia and China suggested they are likely to sign an agreement on the delivery of 50billion cubic metres of gas per year via a new pipeline, the Asian Force Siberia 2.

Meanwhile, Putin’s ‘special military operation’ is under threat from a well- coordinated Ukrainian counter-offensive, which has undermined his credibility and political strength within the Kremlin. However, Putin looks to have become even more desperate in recent days moving to annexe a large part of the eastern Donbas region. Presumably so that if Ukraine attempts to re-capture this area, he can claim it is a direct attack on Russia. Putin has ordered a partial mobilisation, meaning some 300,000 military reservists will be drafted to bolster Russia’s forces in Ukraine. This has prompted civil unrest despite public opposition to the war now being outlawed and made punishable with up to 15 years in prison.

Partial mobilisation appears to be creating further turmoil within Russia. Putin is being backed into a corner and could become more dangerous. At the moment he has chosen the path of escalation. Meanwhile, Ukraine has said Russia must face punishment and President Zelensky has called for the creation of a special war tribunal and detailed alleged war crimes by the Russian military.

Turkish president Erdogan recently met Putin in Uzbekistan and had extensive talks. He is reported to have come away with the impression that the Russian leader wants ‘an end to this as soon as possible.’ PM Liz Truss speaking at the UN said Putin’s actions are a clear admission his invasion of Ukraine is failing. How would the cost of re-building Ukraine’s infrastructure be funded? Would the West remove some sanctions on Russian oil and gas with funds being used to pay the repair bill?

We are all paying the price for the war, Ukraine in lives and Europe in higher energy and food bills.

Everyone is hoping for a peace, but at the moment this still looks a big ask. Central bankers would certainly welcome a peace deal as it would help drive down gas and food prices and remove quite a lot of the inflationary pressure.

What have we been watching?

Is reality finally dawning on global markets? Jerome Powell, Chair of the US Federal Reserve (Fed) made it pretty clear last week. ‘We have to get inflation behind us. I wish there was a painless way to do that. There isn’t’. Risk assets sold-off, the 2-year US Treasury yield pushed above 4% to its highest level since 2007 while the US Dollar strengthened with Sterling dipping to $1.0350 in reaction to a rather aggressive mini-budget. Putin’s ‘sabre-rattling’ probably didn’t help the market mood either!

In the UK, it was a very busy week with details of the government plan to help businesses with energy costs, the Bank of England interest rate announcement and the new Chancellor’s ‘mini-budget’.

The Bank of England (BoE) raised interest rates by 0.5% to 2.25% but amid a clear divergence of views, with 5 votes in favour. Three committee members voted for a more aggressive 0.75% hike while one wanted just 0.25%. The BoE expects CPI inflation to peak at just under 11% compared with 13% previously due to the government energy support package. The BoE voted unanimously to proceed as planned with the active phase of QT which involves reducing the stock of gilts held by the Bank by £80bn over the next 12 months.

How the BoE will navigate tightening at a time when the government is borrowing significantly more to fund household and business energy bills remains to be seen and the recent fiscal measures announced may drive changes in near-term BoE decisions.

The UK mini-budget has driven substantial weakness in UK Gilts and Sterling, which briefly tumbled to an all-time low of $1.0350. The proposed unfunded tax cuts and increased government spending have driven investors to reassess the outlook for UK government debt. In addition, this effort to accelerate growth may exacerbate our inflation problem and money markets now expect more than 165bps of rate increases by the next meeting in November, with a possible emergency hike as soon as this week, with the 2-Year Gilt at c.4.5%. The measures presented in the mini-budget include income tax cuts from April 2023 (from 20% to 19%), the removal of the additional rate of 45%, an increase in the nil-rate band for stamp duty on housing, national insurance cut from 6^th November to 12% (reversing recent rise in April) and corporation tax to remain at 19%, reversing the proposed hike to 25% in 2023.

The Institute for Fiscal Studies is now projecting that borrowing will be over £110 billion by 2026-27, which is more than £80 billion higher than the £32 billion forecast by the Office for Budget Responsibility in March.

Eurozone industrial production was much weaker than expected in August contracting by 2.4%.

In the US, the Fed settled for another 0.75% interest rate hike but the key message to investors came from the updated ‘dot plot’ forecast guidance. The majority of Fed policy makers now project interest rates of between 4.5%-4.75% at the end of 2023. This implies a further 1.5% of interest rate hikes from here. Markets have been worried that too fast a pace of interest rate hikes will push the economy deeper into recession and that given this the Fed would then be forced to ease off. The latest guidance looks to have dashed hopes that the pivot to an easing policy by the Fed would begin next year. Curiously, even under this higher interest rate guidance, the Fed’s forecast for US economic growth remains relatively resilient. The Fed projected GDP growth for 2023 is 1.2% although this is still below-trend.

Brent oil has fallen below $85 following the latest interest rate guidance from the Fed, fears about global recession and a fresh 20-year high for the US dollar.

Finally, following last week’s Alpha Bites ‘chips with everything’, news that leading chip making nations including, the US, South Korea and Japan are forming alliances to secure their semiconductor supply chain and to stop China from reaching the cutting-edge of the industry. Taiwan and South Korea are estimated to account for 80% of the global semiconductor foundry market. Perhaps, another reason that China has its sights on returning Taiwan to the fold?

Read Last Week’s Alpha Bites – Chips with Everything!

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The Bear and Trident

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