Aurelia Butler

Good morning. Ethan here. Rob is on hiatus and, after today, so is Unhedged. Regular service resumes September 5, when Rob will make his much-anticipated return. While we’re off, why not read Martin Sandbu’s always interesting Free Lunch or listen to Katie Martin talk about quantitative tightening? For the next couple weeks I’ll be helping out elsewhere in FT-world. In the meantime, complaints, ramblings and new ideas are always welcome: [email protected]. The Fed-markets disconnectHere are some snippets from Federal Reserve officials’ speeches yesterday. Hard to scream much louder than this:[St Louis Fed president James] Bullard said he isn’t ready to say inflation has peaked and it remains important for the Fed to get its target rate to a range of 3.75 per cent to 4 per cent by year-end . . . He also said that he sees about an 18-month process of getting price pressures back to the Fed’s 2 per cent target“We need to get inflation down urgently,” [Minneapolis Fed president Neel] Kashkari said . . . “We need to get demand down” by raising interest rates. Economic fundamentals are strong, he said, but whether the Fed can lower inflation without sending the economy into a recession, “I don’t know”.[Kansas City Fed president Esther] George said the pace and ultimate level of future rate rises remained a matter of debate. “To know where that stopping point is . . . we are going to have to be completely convinced that [inflation] number is coming down.”The Fed is insisting, loudly and repeatedly, that it’s serious about raising interest rates. Markets, as we’ve discussed before, and has been widely noted, are not buying it. Why the disconnect? I can think of three potential reasons:Markets are optimistic about inflation. They think it will moderate fast enough that the Fed can pivot to slashing rates. Unhedged disagrees, but you can find smart people like the Institute of International Finance’s Robin Brooks or JPMorgan’s Marko Kolanovic making this case.Markets don’t believe the Fed’s commitment to fighting inflation. They think a weakening economy will force the Fed into lowering rates, even if price pressures stay hot.Market pricing, for some reason, isn’t reflecting a fundamental view of the economy. I have no idea how to assess the likelihood of this. But for what it’s worth, the FT reported yesterday that technical factors, such as hedge funds closing out short positions, have been behind the recent equities rally.Whatever the reason, former Fed vice-chair Bill Dudley argues in an op-ed yesterday that markets’ disbelief is harming the US central bank’s policymaking. It is loosening financial conditions right when the Fed wants them tighter. Dudley wants chair Jay Powell, who will speak publicly next Friday, to ram his message through Mr Market’s thick skull:Powell must take care to disabuse markets of the notion that the Fed will soon be done tightening monetary policy. Many investors appear to have reached this conclusion based in part on Powell’s statement in July that future interest-rate increases will be data-dependent, ignoring his repeated [insistence that the Fed is projecting] a peak considerably above what financial markets expected . . . Powell must make clear that even if the Fed pivots to smaller interest-rate increases in coming months, that does not necessarily indicate a lower peak . . . Many see his warning as mere rhetoric, designed to keep inflation expectations down. They think that once the economy slows, unemployment rises and inflation falls, the Fed will start cutting interest rates long before the 2 per cent target has been achieved.Dudley’s point is about messaging. And yes, if markets think the Fed’s inflation-fighting pledge is suspect (reason 2), some tougher talk — perhaps a Bank of England-style promise to prioritise inflation over growth — could scare them straight. But if, instead, markets believe inflation is about to subside (reason 1), what can Powell say to dispel that? The Fed has no more insight into where the economy is going than investors. And if markets are right, it’s hard to believe the central bank would raise rates in an economy that’s slowing fast while inflation numbers tumble. That is the bind of the Fed being data-dependent: it applies on the way down, too.Readers reply on credit risk Wednesday’s newsletter made the point that how scary credit risk looks depends on where you think interest rates are going. A number of readers wrote in to register their thoughts.Pascal Blanqué of the Amundi Institute noted a few reasons to be optimistic about corporate credit:Defaults were after all rather muted in the 70s. Corporates reimburse in nominal terms. Real rates are still low. This happens when you target nominal growth with low real rates. Buying time.Inflation helps debtors, and that’s no less true for corporate debtors. But there is a more pessimistic view — that inflation will stop central banks from intervening when the credit cycle turns down.Deutsche Bank’s Jim Reid makes this argument well (thanks to Dec Mullarkey at SLC Management for sending along). Reid argues that structurally higher inflation will limit how much loose monetary policy is possible. If a US recession comes in late-2023, chances are Congress will be controlled by Republicans, likewise limiting fiscal policy. A recession plus little policy support gives you a big rise in defaults:

This view, of course, hinges on the Fed sitting back and watching it happen. Would it do that? Mullarkey adds:I think there will continue to be sensitivities around the risk of financial contagion and employment dislocations when recessions hit. Therefore, some version of stewardship will continue. However, if dogged inflation neutralises central banks’ flexibility then high real rates will likely prevail and push average default rates higher.In the end, it’s all about inflation.One good readRIP to Pixy, the flying selfie drone. More

Energy-rich Middle East states are set to reap up to $1.3tn in additional oil revenues over the next four years, according to the IMF, as they enjoy a windfall that will bolster the firepower of the region’s sovereign wealth funds at a time when global asset prices have sold off.The IMF’s projections underscore how high energy prices driven by Russia’s war in Ukraine are buoying the Gulf’s absolute monarchies while much of the rest of the world grapples with soaring inflation and fears of recession. Jihad Azour, IMF director for the Middle East and north Africa, told the Financial Times that relative to expectations before the war in Ukraine, the region’s oil and gas exporters, particularly Gulf states, “will see additional cumulative oil revenues of $1.3tn through 2026”.The Gulf is home to some of the world’s biggest oil and gas exporters, and several of its largest and most active SWFs. These include Saudi Arabia’s Public Investment Fund, the Qatar Investment Authority, Abu Dhabi’s stable of vehicles, including the Abu Dhabi Investment Authority, Mubadala and ADQ, and the Kuwait Investment Authority.The $620bn PIF, which is chaired by Saudi Crown Prince Mohammed bin Salman, invested more than $7.5bn in US stocks in the second quarter, including in Amazon, PayPal and BlackRock, as it sought to take advantage of falling stock prices, according to market filings.Gulf SWFs were similarly active during the pandemic as they looked to capitalise on the market volatility triggered by the Covid-19 crisis. During the global financial crisis in 2009, they took advantage of the turmoil to snap up stakes in distressed western companies. In recent years, many of the funds have been focusing on sectors such as technology, healthcare, life sciences and clean energy as governments pursue returns on investments, but also seek to diversify economies and develop new industries. Azour said it was important that the Gulf states used the latest windfall to “invest in the future”, including preparations for the global energy transition. “It’s an important moment for them to . . . accelerate in sectors like technology [domestically] as this is something that will allow them to increase productivity,” he said. “In addition, their investment strategy could benefit from the fact that asset prices have improved for new investors, and the capacity to increase their market share in certain areas are also opportunities.”

The IMF’s Jihad Azour said Gulf states should use the windfall to ‘invest in the future’ © Karim Sahib/AFP/Getty Images

But he added that it was critical that they maintained fiscal discipline and momentum on reforms designed to reduce their countries’ dependence on oil. Traditionally, the health of the Gulf states’ economies has tracked the volatility of oil prices with state spending, fuelled by petrodollars, the main driver of business activity. As a consequence, booms have often been followed by downturns. The bonanza comes after years of subdued growth across the Gulf that caused governments to raise debts, tap into their reserves and slow state projects.But Saudi Arabia, the world’s top oil exporter and the region’s biggest economy, has been on a massive spending spree led by the PIF, which has been tasked with developing a raft of megaprojects intended to modernise the conservative kingdom while seeking out investments overseas. The PIF is expected to be one of the main beneficiaries of the oil boom as Saudi Arabia is on course to record a budget surplus of 5.5 per cent of gross domestic product this year — its first surplus since 2013 — and forecast to produce economic growth of 7.6 per cent, its fastest pace in a decade.

The IMF estimates that for the second consecutive year the PIF is expected to undertake more investment in 2022 than the government. In a report this week, the fund cites “pressures to spend oil windfalls and deviate from fiscal prudence” including through the PIF, as one of the kingdom’s downside risks. “What is going to be really important is how they [Gulf states] manage this new cycle and how they maintain, at the same time, the benefits of the additional liquidity and the policies that will not lead them into procyclicality,” Azour said. The IMF forecasts that economic growth in the Gulf Cooperation Council, which includes Saudi Arabia, the United Arab Emirates, Kuwait, Bahrain, Qatar and Oman, will accelerate from 2.7 per cent in 2021 to 6.4 per cent this year. More

The writer is professor of political economy at the University of Cambridge and author of ‘Disorder: Hard Times in the 21st Century’Across the world, politicians are ever more desperately looking to contain the explosive consequences of the energy crisis. In those parts of Asia, the Middle East and Africa already mired in multiple economic and political difficulties, the crisis is proving catastrophic. Those who import liquid natural gas must now compete with European latecomers to the LNG market seeking an alternative to pipelined Russian gas. In early summer, Pakistan was unable to complete a single LNG tender. In poor countries, a large proportion of the state’s resources go on subsidising energy consumption. At prevailing prices, some cannot: earlier this month, the Sri Lankan Electricity Board imposed a 264 per cent increase on the country’s poorest energy users.In Europe, governments want to alleviate the dire pressures on households as well as energy-intensive and small businesses, while letting spiralling prices, pleas to consume less and fear about the coming winter drive down demand. Fiscally, this means state funding to reduce rising energy bills by subsidising distributors, as in France, or transferring money to citizens to pay those bills, as in the UK.What is not available anywhere are quick means for increasing the physical supply of energy. This crisis is not an inadvertent consequence of the pandemic or Russia’s brutal war against Ukraine. It has much deeper roots in two structural problems.First, unpalatable as this reality is for climate and ecological reasons, world economic growth still requires fossil fuel production. Without more investment and exploration, there is unlikely to be sufficient supply in the medium term to meet likely demand. The present gas crisis has its origins in the Chinese-driven surge in gas consumption during 2021. Demand grew so rapidly that it was only available for European and Asian purchase at very high prices. Meanwhile, respite from rising oil prices this year has only materialised when the economic data from China is unpropitious. In the International Energy Agency’s judgment, it is quite possible that global oil production will be inadequate to meet demand as soon as next year.For much of the 2010s, the world economy got by on the shale oil boom. Without US production more than doubling between 2010 and 2019, the world would have been trapped in a permanent oil crisis since 2005, when conventional crude oil production — oil drilled without hydraulic fracturing or from tar sands — stagnated. But American shale cannot expand at the same rate again. Although the largest US shale oil formation — the Permian Basin in western Texas and south-eastern New Mexico — is projected to reach record output next month, overall US output is still more than 1mn barrels per day below what it was in 2019. Even in the Permian, daily production per well is declining.More offshore drilling, of the kind opened up in the Gulf of Mexico and Alaska by the Inflation Reduction Act, will require higher prices, or investors willing to pour in capital regardless of the prospects for profit. The best geological prospects for a game changer akin to what happened in the 2010s lie with the huge Bazhenov shale oil formation in Siberia. But western sanctions mean that the prospect of western oil majors helping Russia technologically is a geopolitical dead end.Second, little can be done that would immediately accelerate the transition from fossil fuels. Britain’s planned micro nuclear reactors will not be completed until the 2030s. Running electricity grids on solar and wind base loads will require technological breakthroughs on storage. It is impossible to plan with any confidence what progress will have materialised in 10 years, let alone next year. But precisely because an energy transition is essential to reduce fossil fuel consumption, large-scale, blue-sky investment is imperative.The only way forward is realism for the short term, recognising that there is no way back to cheap energy, allied to radical, long-term ambition. A grasp of geopolitical realities is also essential. The US remains by some distance the world’s dominant power. Its naval power guarantees open waters for international trade. World credit markets depend on dollars. But Washington does not have the power to direct China and India’s energy relations with Russia. This coming winter will bring a reckoning. Western governments must either invite economic misery on a scale that would test the fabric of democratic politics in any country, or face the fact that energy supply constrains the means by which Ukraine can be defended. More

“It is concerning that economic growth may slow due to limited export recovery going forward, while high inflation pressure continues and economic sentiment is also partly affected amid worsening external conditions,” the ministry said in its latest monthly economic assessment.The ministry cited continued inflation pressure globally, monetary tightening in major countries, economic slowdown in the United States and China and the lengthening war in Ukraine as increasing downside risks. More

Inflation figures from Japan, which could put the central bank’s ultra-loose monetary policy under even more intense scrutiny, and a smattering of Chinese earnings are the juiciest morsels for investors in Asia to get their teeth into on Friday.Analysts expect Japan’s core annual inflation rate in July rose to 2.4% from 2.2% in June. That would be the highest since late 2014 and further above the Bank of Japan’s goal of 2.0%.It would mark months above target, raising further doubts over the BOJ’s policy of buying unlimited amount of bonds to cap the 10-year yield at 0.25%, a policy that runs counter to the rate-raising trend across the developed world.The divergence between Japanese and U.S. yields has pushed the yen down 15% so far this year, on course for its biggest fall against the dollar since 2013 and third steepest since the era of free-floating exchange rates began in the early 1970s. The yen is trading around 136 per dollar, and an uncomfortable inflation print could push it closer towards last month’s 24-year low near 140 per dollar. GRAPHIC: US-Japan 2-year yield spread (https://fingfx.thomsonreuters.com/gfx/mkt/klvykwljevg/JPUS.png) In China, retail banking giant China Merchants Bank releases half yearly results. These could offer a glimpse into the impact of the country’s debt-ridden property sector on banks, as a growing number of homebuyers threaten to stop paying mortgages on hundreds of unfinished housing projects.Results are also due from smartphone maker Xiaomi (OTC:XIACF) Corp, which is struggling amid the industry’s smartphone volumes falling to a decade low as COVID-19 lockdowns batter demand. Xiaomi started constructing its first car factory in Beijing earlier this year, and aims to be mass producing electric vehicles by the first half of 2024. Future rival EV maker Nio (NYSE:NIO) Inc, meanwhile, also releases Q2 earnings on Friday.Key developments that should provide more direction to markets on Friday:Japan inflation (July)Indonesia current account (Q2)Earnings reports from China Merchants Bank, Xiaomi, Nio (This story has been refiled to clarify day in last paragraph as Friday, not Thursday) More

UK consumer confidence has fallen to its lowest level since comparable records began almost 50 years ago as the rising cost of living stokes concerns over personal finances and economic prospects. In monthly research from data provider GfK, the August index score for overall consumer confidence fell to -44 from a figure of -41 the previous month. That was the lowest reading since the equivalent data was first produced in 1974.The decline in confidence reflects a darkening mood across the UK economy with prices rising at double-digit rates, the largest drop in real wages for more than 20 years, a resurgence of strikes and mounting pressures across public services. The survey was undertaken between August 1 and August 12, a period in which the Bank of England forecast the economy would soon slide into a recession lasting over a year as household struggled to pay energy bills, which are likely to rise more by more than 75 per cent in October compared to now. All five elements that comprise the overall consumer confidence index fell, prompting Joe Staton, a director at GfK, to say, “a sense of exasperation about the UK’s economy is the biggest driver of these findings”.“[They] point to a sense of capitulation, of financial events moving far beyond the control of ordinary people,” he said. Linda Ellett, UK head of consumer markets, retail and leisure at KPMG, said the decline in confidence was likely to weaken retail sales soon even though the figures have held up so far this year. “A widespread reduction in spending ability will lead to drops in demand and changing buying behaviour, both of which will impact the high street and wider economy,” she said. Where people were asked about their personal financial situation, their scores over the past year equalled the low points of the financial crisis in 2008-09 and the austerity period around 2012.But the expectations for their situation over the coming year will cause more concern. That figure has fallen to -31, significantly worse than in either of those two earlier periods. The negative score reflects many more people saying their personal finances are likely to deteriorate rather than improve over the year ahead. “With headline after headline revealing record inflation eroding household buying power, the strain on the personal finances of many in the UK is alarming,” said Staton. “Just making ends meet has become a nightmare and the crisis of confidence will only worsen with the darkening days of autumn and the colder months of winter.”Households were similarly gloomy about general economic prospects with the score declining every month since December last year. In August, it stood at -68, worse than at the height of the first coronavirus wave when the UK was in a strict lockdown — although better than at the time of the global financial crisis.

Households’ assessment of the UK’s economic prospects in the year ahead was -60, more gloomy than at any time since GfK started collecting the data, and 54 points lower than in August 2021. With such low confidence about their finances and the economic situation, households were naturally unlikely to say that now was a good time to make a major purchase. This sub-index fell to -38, down 4 points on the month and from a level of -3 a year earlier. In contrast, with interest rates rising, people increasingly think now is a good time to save. If many increase savings at the same time and reduce spending, it will accelerate the expected economic downturn this autumn. More

WASHINGTON (Reuters) -President Joe Biden’s administration is readying about $800 million of additional military aid to Ukraine and could announce it as soon as Friday, three sources familiar with the matter said on Thursday.Biden would authorize the assistance using his Presidential Drawdown Authority, which allows the president to authorize the transfer of excess weapons from U.S. stocks, the sources told Reuters.The sources, speaking on condition of anonymity, said that an announcement could slip into next week, cautioning that weapons packages can change in value before they are announced.The White House declined to comment.Since Russian troops poured over the Ukrainian border in February in what Russian President Vladimir Putin termed a “special military operation,” the conflict has settled into a war of attrition fought primarily in the east and south of Ukraine.Washington has sent billions of dollars in security assistance to the Kyiv government. More