Those looking for a respite in the inflation scare are not getting it.

Cyclical stocks continue to outperform growth stocks while the risk off atmosphere has now been aggravated by the crisis in Ukraine.

Still the strong labour market, with nominal labour compensation rising more than 10% over the past year, should continue to support demand in America despite rising prices.

US private industries’ total wages and salaries rose by 11.2% YoY in January and were up 10.6% YoY in the whole of 2021, the highest annual growth since 1984.

US private industries’ total wages and salaries %YoY

Source: US Bureau of Economic Analysis

Note: Annual figures for 1980-2021 and monthly data for January 2022.

This will keep pressure on the Fed to tighten, which is why cyclical stocks continue to be favoured over growth stocks.

On this point, the MSCI World Value Index has now outperformed the MSCI World Growth Index by 14.2% so far this year.

MSCI World Growth Index relative to MSCI World Value Index

Note: Performance on a total-return basis. Source: Datastream

Note: Performance on a total-return basis. Source: Datastream

The best hope for the market of a change in the Fed’s assumed tightening stance will come from deteriorating financial conditions.

A change in the Fed’s stance can only happen after credit spreads have risen materially to justify such a change in the central bank’s stance and that rise in credit spreads in the US has only just begun and doubtless has further to run.

The Bloomberg Barclays US high-yield and investment-grade corporate bond yield spreads have risen from their recent lows of 271bp and 91bp respectively in late December/early January to “only” 376bp and 130bp.

This compares with the high of 1,100bp and 373bp reached in March 2020 at the height of the pandemic panic.

Bloomberg Barclays US corporate bond yield spreads

Source: Bloomberg

Will Europe Tighten Rates with the US?

Meanwhile, the ECB has also to think about tightening given that the 5.8% YoY Eurozone inflation print in February was the highest inflation number since the establishment of the euro at the beginning of 1999.

Eurozone inflation

Source: Eurostat

The rise has been driven mainly by the increase in energy prices.

Eurozone energy inflation rose from 25.9% YoY in December to 31.7% YoY in February.

As a result, energy prices contributed an estimated 3.46ppts to the February Eurozone inflation, compared with 2.46ppts in December.

The predictable result has been pundits competing to forecast the end of quanto easing in Eurozone and the beginning of monetary tightening following ECB head Christine Lagarde’s comment at the last ECB meeting on 3 February that inflation “has further surprised to the upside”.

Money markets now expect that the first ECB rate hike of 10bp will be in early September with the quanto easing programme ending before that. (Money markets expect a 10bp rate hike in early September and 24bp by year end.

This is a remarkable change of view from what was expected by the consensus at the end of last year, which is after all only nine weeks ago.

Still, it is also important to note that the ECB head stuck to the so-called “sequencing” policy where rates can only go up after the so-called asset purchase programme (APP) is phased out.

This writer has severe doubts whether the ECB will move as quickly as current market expectations.

Bundesbank President Joachim Nagel, for example, is pushing only for easing to be phased out “over the course of this year”, which probably means by September at the earliest.

Certainly, the action in peripheral bond spreads will be watched closely by the ECB and also by Eurozone politicians seeking to implement the fiscal integration agenda.

Indeed the ECB’s policy of closet yield curve control whereby it was targeting nominal bond yields looks, for now at least, in tatters as a result of Lagarde’s change of tone.

Amid concerns that the ECB will soon be withdrawing its bond buying bid from the market, Italian and Greek bond spreads have started to surge.

The 10-year Italian and Greek government bond yield spreads over the 10-year German bund yield have risen by 26bp and 92bp respectively so far this year to 161bp and 243bp.

Italian and Greek 10-year government bond yield spreads over 10-year German bund yield

Source: Bloomberg

How long this can go on without the ECB changing its tune again is an interesting question.

In this writer’s view it cannot be too long.

It is also the case that the negative action in corporate credit spreads in the Eurozone has also been more marked than in America because the ECB has been buying far more corporate debt than the Fed and investors naturally fear the consequences if it stops doing so.

Thus, the Eurozone high-yield corporate bond spread has risen by 134bp from a recent low of 320bp on 7 January to 454bp, while the US high-yield corporate spread is up 66bp since early January.

Eurozone and US high-yield corporate bond spreads

Source: Federal Reserve Bank of St. Louis, Bank of America

The ECB owned €357bn (US$408bn) of corporate bonds at the end of January, while the Federal Reserve has already sold all of the US$14bn of corporate bonds it bought during the pandemic.

Eurozone and US Monetary Policy Are Not in the Exact Same Place

Meanwhile, if inflation in the Eurozone has come in well above ECB expectations, the hawkish case is less clear cut than in America as regards the labour market.

This is because, so far at least, there is much less evidence of wage pressures in the Eurozone compared with the US.

It is also the case, as already noted, that a large part of the inflation surge is energy driven.

The Eurozone wages and salaries index rose by 2.3% YoY in 3Q21, compared with a pre-pandemic high of 2.9% YoY reached in 2Q19.

Eurozone wages and salaries index %YoY

Source: Eurostat

The 4Q21 data will be released on 18 March. While the ECB’s indicator of negotiated wages actually slowed from 2.58% YoY in 3Q19 to 1.35% YoY in 3Q21 and was 1.51% YoY in 4Q21.

Eurozone indicator of negotiated wage rates (%YoY)

Source: ECB

As for Germany, the index of agreed hourly earnings rose by only 1.1% YoY in February, the lowest growth rate since March 2011.

Germany index of agreed hourly earnings %YoY

Source: Federal Statistical Office

Still, it is worth noting that Eurozone inflation expectations remain quite elevated despite the ECB’s recent so-called hawkish pivot.

The Eurozone 5-year 5-year forward inflation swap rate has risen from a low of 0.72% in March 2020 to 2.11% on 4 March 2022, the highest level since August 2014.

Eurozone 5-year 5-year forward inflation swap rate

Source: Bloomberg

Energy Is Headed Higher Regardless of What Happens in Ukraine

Meanwhile, if wages are rising there is no doubt that the surge in energy costs in Europe is putting real pressure on lower-income households.

Unfortunately, it also remains the case that, absent the arrival of a new more lethal Covid variant, the price of oil is likely to head much higher.

This is why any correction in oil, on any resolution of the crisis in Ukraine, should be viewed as a buying opportunity.

The underlying lack of supply, which is pushing the oil price higher, is evident from the extreme backwardation in the oil market.

The Brent crude oil spot price was a record US$18 higher than the six-month futures price on 2 March, and the gap is now US$16.

Brent crude oil backwardation (Six-month futures – spot price)

Source: Bloomberg

Meanwhile, US shale output continues to disappoint relative to the incentive to produce suggested by a higher oil price.

Oil production in the seven US shale regions in January was still 8.4% below the peak reached in November 2019.

US oil production in seven shale regions

Source: US Energy Information Administration (EIA)

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