The UK’s economy continues to be under high pressure. While high inflation affects all countries, Truss’s historical tax cut and its outlined budget sent markets crashing. In particular government bonds alongside the British Pound experienced an alarming development, such that the BoE had to intervene and stabilize the economy. This had a brief stabilization effect, as the support was for a limited amount of time, as shown in Figure 1. This short support is largely due to the fact that it goes against the plan of central banks globally which try to reduce their balance sheets following the substantial interventions during Covid-19. This financial emergency led to Truss’s resignation from her position as prime minister. Her initial rival Sunak took over the office soon after and faces a tough situation ahead. Following this turmoil, markets have somewhat calmed down with Sunak’s appointment as PM and his experience in former financial positions. Meanwhile, other countries are still committed to raising interest rates. For the Fed, it is widely expected that rates will be raised by another 75bps in early November reaching 4%. With this following hike, officials say that further hikes are to be expected, although the magnitude might slow down. Further hikes are increasingly likely as the inflation rate is not really cooling down, and remains at 8.2%, down from 8.3% in the prior month. The relatively stable decline in equities is also unlikely to stop any time soon. Not only is there a constantly looming threat of a recession, but the equity market also tends to be correlated to central bank assets, as shown in Figure 2. This relationship is intuitive, as more assets or capital in the market are deployed. Furthermore, during Covid-19, much of the injected capital flew directly into stocks. With the back scaling of available capital, it is withdrawn from more risky capital, which is frequently stemming from equities. Although cryptocurrencies took a huge hit in early 2022, since July 2022, their performance is positive unlike bonds, stocks, or gold. This is a relieving sign for the industry, as cryptocurrencies tend to be strongly correlated with other asset classes at the beginning of a drawdown, but is the first asset class to recover from it. In this state, the asset class usually regains its attractive property of being non-correlated to other asset classes. Another highly intriguing development is taking place with Web3 applications. Web3 applications essentially fulfill the same role as technology companies leveraging the internet. However, unlike these technology companies, Web3 platforms are built decentral and are not maintained by a single entity. The current state of the Web3 industry strongly resembles these technology companies during the dot-com bubble. Figure 4 highlights a few key similarities. Venture investing in these types of companies also has not taken a large hit, compared to most other asset classes. This is in particular notable, as traditional venture investing took a substantial hit in 2022. Figure 5 shows the consistent decline in venture investments since Q4 2021.
For once, inflation was not the most prominent topic over the past two weeks. Instead, it’s the UK government and its optimistic tax cut. The UK’s new prime minister Truss promised a large tax cut in her election campaign. If implemented, the tax cuts would lead to losses of around £40bn and would be the second-highest budget cut in the past 50 years. Figure 1 shows a breakdown of the largest budget adjustments over the past 50 years. This seems very optimistic given the already existing struggles with ever-soaring inflation at the 10% mark and the severe gas/oil crisis in Europe. When further details on its implementation were revealed, the UK economy faced severe issues and could only narrowly avoid a complete disaster. The British Pound almost dropped to an equivalent level to the US Dollar for short time. Especially, the bond market crashed, as the BoE initially wanted to step back its bond buying program introduced after Covid-19. Figure 2 shows the drop in the value of UK gilts with maturities exceeding 15 years. Although they have been declining since 2020, the most recent drop is substantial. Currently, UK gilts are down 54%. A complete crash could only be avoided by the BoE strongly intervening in the bond market to stabilize the situation. It is very unlikely that the BoE can afford to step back its bond buying program any time soon, as the risk of fire sales is large, especially, if market participants know that UK gilts are no longer stabilized by the BoE. With rampant inflation across the world, central banks are continuing their consistent and strong hikes to combat further rising inflation. These interest rate hikes have led to substantial bond yield increases. The G7 average 10-year bond yields have now surpassed their average yield of the past two decades, as shown in Figure 3. Given the current development, bond yields could rise to their average at the beginning of the 21st century and likely stay there for a while until inflation is under control to a large degree. While it is debatable whether central banks acted fast or not; when they started doing so, the frequency and magnitude were substantial. This is especially true for the Fed. Figure 4 shows a comparison of the speed and magnitude of the current hikes compared to other historical hike cycles. With the current expectation of two further hikes (each between 50bps and 75bps), the current cycle is not only the largest in terms of magnitude but also the fastest at any given time. Despite the strong hikes of the Fed already, inflation in the US still increased by 0.4% to 8.2%, which was higher than expected and is likely to put further pressure on the Fed. This development is likely to emphasize further rate hikes, potentially even higher than currently anticipated. Equities also continue to be under pressure. After reaching their low of the year in mid-2022, they bounced back until August 2022. Since then, they have been consistently facing losses and reached new lows in 2022. The S&P 500 index is down 25% YTD, while the tech-heavily Nasdaq is down almost 35% YTD. The outlook is certainly not great with rising interest rates and a looming global recession. Additionally, it is worrying that the Covid-19-induced bull run strongly resembles the development during the dot-com bubble. Figure 5 highlights the similarities between the two tech bull runs and potentially bubbles.
Central banks continue to be in the spotlight. Over the past months, it is hard to find a central bank that has not raised interest rates at least once. Inflation remains at four-decade highs in most countries, despite the measures taken by central banks so far. The Fed raised interest rates by another 75bps this month and maintains its stance to aggressively combat inflation. This led the 2-year Treasuries to surge above 4%, for the first time since before the global financial crisis, and increases the likelihood of a recession as well as potentially sharply declining equities. The latest hike increased the federal fund rate to 3% - 3.25%. The ECB also raised its interest rate by 75bps in September, while the Bank of England increased its rate by 50bps. The ECB’s rate is now at 1.25% and the UK’s is at 2.25%. Switzerland also raised its rate by 75bps which brings it into positive territory as the last country in Europe. In the middle East, Saudi Arabia, the UAE, and Qatar follow the Fed with their 75bps hikes as well. Across the developed countries, Japan remains the last country with currently negative rates at -0.10%. September 2022 has also been highly relevant for the currency market. The dollar has strengthened substantially over the year. Compared to the Euro, it appreciated from around 0.9$/€ in 2020 to 1.03$/€. The British Pound declined strongly. The latest tax cut in the UK is threatening even higher inflation and will force the BoE to act more aggressively in tightening. After the announcement, the Pound dropped below 1.1$/£, and some speculate that the Pound could fall below parity to the USD. The Japanese Yen also experienced substantial movements, as the country is buying Yen again for the first time in nearly a quarter century. In spite of the negative developments of equities in 2022 and their even more grim prospect, equities are doing great on a historical scale. Figure 1 shows the growth of global equities with the impact of several crises
The still high inflation and the potential reaction from the Fed continue to dominate the financial market news. Last Friday when Powell gave a short speech on how the Fed will move forward, stock markets crashed amid a more hawkish stance than expected. He emphasized that inflation has to be brought down relatively soon even if it hurts businesses and households, at least in the short term. Although inflation decreased for the first time in months, the inflation rate is still way too high at 8.5%. Following the speech, another 75bps hike is not outside the realm of possibility. Unlike earlier estimates, it is also likely that the federal fund rate will be around 4% in the short term and will persist for some time. The degree of interventions does depend substantially on the economic data and whether the measures taken achieve their intended goals. This led to a massive drop in equity prices, such as the Dow Jones which dropped more than 1,000 points in a single day. It also hurt cryptocurrencies substantially. Bitcoin dropped below the $20k mark for the first time since June. In Europe, the situation looks very different. While inflation is still soaring with a new record high of 8.9% in 2022, its interest rates are still at 0bps even after its 50bps hike in July. It is likely that inflation will continue to soar even if substantial rate hikes take place soon. The ECB’s measures have been very mild compared to the Fed’s and other central banks and were widely expected to stay on the milder side. However, with the continuously growing inflation, the ECB is forced to intervene. For its September meeting, it is expected that a rate hike of at least 50bps will take place, if not 75bps. These developments also make a recession in Europe more and more likely. The impact of the war, especially energy as a whole, further exacerbates this likelihood. In the UK, inflation is an even bigger problem, as the 10% mark was surpassed in July 2022. This is very relevant, as the BoE was very active in 2022 in rising interest rates while the ECB was not. The BoE’s current base rate is at 1.75% after five small interest rate hikes from December 2021 to June 2022 and the subsequent 50bps hike at the beginning of August. For the next meeting, another 50bps or even 75bps are considered as likely. Current expectations are around a base rate peak of 3.75% at the beginning of the next year. It is questionable whether the rate will in fact be “that low”, as the Fed pointed out 4% for a while is a possibility. This is concerning for the UK, as the US has both, a lower inflation and a currently decreasing inflation.
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