28 December 2022: UK showing no signs of recovery

2022 has been the year in which Central Banks returned to centre stage after years of historically low interest rates as inflation remained low.

It is now clear that the country suffered a severe self-inflicted wound by voting to Leave the European Union. Brexit has contributed to the economy shrinking by close to five per cent since the vote took place in 2016.

Even while the terms of Brexit were being negotiated, the Pandemic hit, which saw furlough payments and other support packages introduced by the Government that pumped an unprecedented amount of liquidity into the economy and created the start of the rise of the inflation and the end of the low interest rate era.

The Bank of England began to hike rates last December and has continued to do so at every meeting since. The Bank’s Governor acknowledged as Autumn turned to Winter that the country was likely to fall into a recession that could last for five quarters and inflation would take some time to return to the target of 2% that has been set by the Government.

So, as 2022 comes to a somewhat ignominious end, the signs are that Andrew Bailey’s prediction will be proved correct. The country is experiencing stagflation as prices continue to rise, despite continued tightening of interest rate policy, while data releases for the fourth quarter show that activity and output are slowing.

There is significant unrest across several sectors, with public sector workers from train drivers to nurses striking for higher pay and conditions.

Rishi Sunak, the country’s third Prime Minister this year, and his ministers have so far managed to resist demands for inflation busting pay claims and the situation is only likely to worsen as the New Year begins.

Sterling has had a turbulent year. Against the dollar, it collapsed to a low of 1.0340 as the markets lost faith in the then Chancellor Kwasi Kwarteng and his budget for growth. It took some major work to rebuild trader’s confidence as the pound recovered to trade around the 1.20 level as the year-end approaches.

The prognosis for the New Year is that the patient will continue to suffer as the economy remains weak, but it will be mostly affected by what happens across the pond as interest rate differentials begin to favour the pound.

If one is driven by the employment market when deciding on the relative strength of the U.S. economy, then a recession is something of a distant concern, with around 250k new jobs being created on a monthly basis.

The unemployment rate has remained at 3.7% for a couple of months, which in the past has denoted full employment.

Wages are continuing to rise, although the pace has eased over the fourth quarter. During the Spring and Summer, there was a significant amount of job-hopping, which saw thousands of workers change jobs in order to take advantage of higher salaries. This trend has abated somewhat recently as workers become more content as they listen to reports that a slowdown is coming.

The December non-farm payrolls report, which will be published in a little over a week’s time, will be closely inspected for any change to the underlying strength of job creation.

At this point in the cycle, anything over 200k new jobs created should see the Fed continue to hike rates, although it tempered the size of increments in its latest meeting to fifty basis points from seventy-five basis points.

The minutes of the latest meeting of the FOMC will be published next Wednesday and, with the employment report two days later, together they could set the scene for both the economy and the fate of the dollar over the first quarter.

There will be eight FOMC meetings in 2023, the first of which will take place on February 1st.

The dollar index showed considerable strength over the first three quarters of 2022, reaching a high of 114.78 as the Fed continually signalled that it was in a fight with inflation that it was determined to win. During October, it began to correct as the Minutes of the September FOMC meeting, released on October 12th, had a less hawkish feel that was continued into the next meeting.

While the index remains high historically, the actions of the FOMC in Q1 are likely to determine its path for the first half of the New Year.

The Eurozone stands on the cusp of a disaster that could lead to the end of the experiment.

That line could have been written as the New Year approached at any time in the past five years at least.

The Energy Crisis and the war in Ukraine have followed closely on the heels of a rather uneven end to the pandemic.

This has seen inflation reach levels that are unheard of in the wealthier nations such as Germany and Austria, which have been at the forefront of efforts to use tighter monetary policy to lower prices.

Although the energy crisis has been exacerbated by Russian actions in targeting the German economy in response to their support for sanctions against it over its actions in Ukraine, the food shortages that the invasion has created are just as damaging.

The war will reach its anniversary soon and shows no sign of coming to an end. In fact, there have been escalations even over the past week as Russia steps up its missile attacks on Major Ukrainian cities, while Kyiv shows that it is receiving new weapons by attacking a Russian base five hundred kilometers inside Russia using drones that it hasn’t had access to before.

The ECB drew scornful comments from the new Italian Government for hiking rates at its latest meeting. Words such as unfathomable, crazy, and disastrous were uttered by the new Prime Minister Giorgia Meloni, who appears to be less radical than her right-wing predecessors.

The ECB President, Christine Lagarde, has now apparently decided to side with the frugal five who are driving the Central Bank towards even tighter monetary policy by use of Jumbo rate hikes of seventy-five basis points.

Rates of Italian Government Bonds have risen considerably in recent times, and 2023 could see a test of the implicit ECB guarantee of the EU as Italy comes close to running out of money. Both sides will need to draw back from the brink, as Italy would suffer considerable damage to its economy from being outside the EU, while Brussels could ill-afford an Italexit.

The euro fell below parity to the dollar again, but the market didn’t have sufficient impetus to see it fall further. It is likely to end the year in a marginally better state, but even if the ECB continues to hike driving the several individual economies into recession, while the Fed begins to end hikes the euro may still suffer by comparison with the U.S. economy.

Have a great day!