| Rafi Gozlan, Chief Economist at IBI Investment House
| Highlights:
- The deterioration in the geopolitical level led to a rapid rise in commodity prices which translated into a rise in the inflation environment. The recent deterioration has led the markets to price as well as a slowdown in global growth including fears of hurting the financial sector.
- The risk of inflation in the short term has risen, but is declining in the medium term. The growing probability of a slowdown will lead central banks to focus more on medium-to-long-term inflation expectations than on short-term inflation developments.
- Developments around the world will not miss the Israeli economy, even if the sensitivity to rising commodity prices is relatively low. We are updating the inflation forecast for the coming year from about 1.5% -2% (1.7%) to about 2% -2.5% (2.3%), but the estimate for the moderation of inflation in the advanced stages of the year into 2023 remains the same.
- Although the inflation environment in Israel is lower than in the US and Europe, partly as a result of lower sensitivity to energy prices, inflation expectations are relatively high, and the curve continues to be very steep despite rising interest rate expectations.
| Beyond the rise in inflation, markets are also starting to price growth hurt
The deterioration at the geopolitical level was a dominant factor in its impact on the markets also in the past week, while it was reflected in a decrease in risk assets alongside an increase in commodity prices. Concerns about the escalation of the military conflict and disruptions in commodity markets continue to be major risk factors, especially after the harsh sanctions imposed on Russia and rhetoric in recent days over an embargo on Russian oil, which has already begun to take root in the Russian oil price.
These measures led on the one hand to a slump, to the cessation of trading in Russian assets and to the closure of the Russian stock exchange, and on the other hand to sharp declines in stock markets, particularly in Europe, with the weakening of European currencies, especially in Eastern Europe. Leading indices in Europe fell sharply by 7% -10%, so that in parallel with a sharp decline in government bond yields, there was a sharp rise in the risk premium inherent in these indices while declining future multipliers to low double-digit levels.
With the exception of a sharp contraction in the eurozone, the current risk premium reflects comfortable pricing in the medium term. While the increase in the risk premium in Europe is understandable against the background of the higher sensitivity to the war between Russia and Ukraine, it is very noticeable compared to the relatively moderate increase recorded in the US.
The continued deterioration in the situation is also likely to lead to a more significant increase in the US risk premium, especially as the response between central banks begins to sharpen, ie an increase in the US compared to the postponement of the monetary contraction in the eurozone.
We continue to assess that until the Russian response to the severe sanctions is clarified, high volatility in the markets is expected to continue, with a further horizontal increase in the risk premium in the markets, which will be reflected in negative pressure on risk assets (equities and credit spreads).
In our previous review, we estimated that the geopolitical risk premium inherent in the markets is not expected to disappear so quickly, and in the last week it has indeed risen a notch. Indeed, Russia is the main gas supplier to Europe (about 50% of total gas imports) and produces about 10% of world oil production, so alongside Russia’s and Ukraine’s main role as wheat exporters, these commodity prices are very sensitive to the geopolitical situation.
Thus the decline over the past week has led to a sharp rise in the prices of these commodities, and stood out in doubling gas prices in Europe (which also led to a sharp jump in the price of coal) in parallel with a 60% rise in wheat and 20% Brent oil prices approaching $ 120 a barrel.
In terms of oil, the emphasis in the short term is on the geopolitical situation and the reduction of oil purchases from Russia, and on the other hand the progress of negotiations with Iran and the heavier pressure on all OPEC countries to increase output, hitherto unsuccessful , But it is likely that as the rise in oil prices accelerates, OPEC countries will find it difficult to remain indifferent to the rise in price.
The continuation of the war between Russia and Ukraine this week also raised the fear of significant and broader damage to global activity, and at the same time led to an increase in the risk premium embodied in the financial sector. Beyond the sharp declines in European and US bank shares, there was also an increase in the short-term liquidity premium, with the widening gap between the FRA and OIS to 3 months in parallel with a horizontal increase in the CDS of banks in Europe and the US.
Surveys of expectations for the business sector for February did not reflect the geopolitical deterioration, but it is likely that this will begin to be reflected starting with the next index for March.
| The deterioration in the geopolitical situation comes at an advanced stage of the business cycle
Of course, the situation in the commodity markets cannot be detached from the advanced stage of the business cycle in which the world economy is located. Although business turnover was disrupted following the Corona crisis, the decisive response of governments and central banks led to a relatively rapid return to pre-crisis activity levels and relative proximity to the pre-crisis growth trend, i.e. to “heated” economies.
Thus, employment data in the eurozone last week indicated a decline to below 7%, lower than the unemployment rate on the eve of the crisis, which stood at 7.2%. In the United States, too, the improvement in the labor market continued with a higher-than-expected level in February and a decline of 3.8%, despite a further slight increase in the participation rate.
Surprisingly, the improvement in employment in February was accompanied by stability in the monthly, so that the annual rate moderated to 5.1% compared with 5.5% in January.
However, it is too early to point to a halt in the wage acceleration, since in addition to this being a single figure, the change in the composition of employment in particular after the Omicron wave probably played a role, so given the continued improvement in the labor market and the labor market, it is better to wait. The wage trend, and it is more likely to expect the wage increase to continue than to curb it.
| Central banks will give greater weight to medium-to-long-term inflation expectations
The improvement in the state of the economy along with the sharp rise in energy prices led to a further acceleration in inflation in the euro area. Thus the general index reached a high annual rate of 5.8% in February, while the basic rose at a more moderate annual rate of 2.7%. The acceleration in the inflation rate in the eurozone was leading in the days as a correction to the tone exacerbated by the ECB, but the fear of geopolitical deterioration is expected to be reflected in a softer tone in next week’s decision.
Although the ECB is expected to complete the acquisition program taken in the wake of the Corona crisis (PEPP), the termination of the APP program and the subsequent increase in interest rates are expected to be postponed at least until a geopolitical calm is observed.
In this respect, the ECB interest rate contracts do reflect a partial probability of raising one interest rate by the end of the year. In contrast, expectations for an increase in the US have moderated to a lesser extent and they reflect an expectation of an interest rate increase to 1.5% by the end of the year. The rest under the influence of the geopolitical deterioration.
However, Powell did not rule out that in the event that inflation accelerates, the Fed will opt for a higher rate of 50 bp. In general, while central banks are unlikely to ignore the rise in the inflation environment in the near term, The growing threat to activity in the medium term is a threat that, if realized, is expected to act as a moderating factor in inflation in this range.
Beyond a certain moderation in expectations of raising interest rates, the assessment of a broader impact on activity as a result of the geopolitical deterioration was reflected in the bond market’s decline in yields throughout the US curve, and more sharply in Europe, with a sharp decline in the real interest rate environment.
Although the decline in real interest rates is supported by the rapid rise in inflation expectations, it also reflects an assessment that the rise in interest rates by the leading central banks is limited, against the background of expected damage to activity as a result of geopolitical deterioration and disposable income.
The sharp rise in the inflation environment in parallel with growing expectations of hurting activity leads us to believe that the focus of central banks in the US and Europe will be more inclined to examine the level of medium- long-term inflation expectations than short-term inflation.
Although central banks cannot influence the supply side, they can influence the demand side through monetary restraint and tougher financial conditions. However, as the geopolitical shock continues (followed by a sharp rise in commodity prices), the probability of hitting global activity increases, so it is more likely that central banks’ emphasis will shift to curbing rising inflation expectations to avoid a prolonged inflationary process.
In the US, the current high inflation environment and the level of medium-long-term expectations (5-10 years) 2.7% -3.25%, certainly support a number of interest rate increases, in order to lead to further tightening of financial conditions (a trend that is supported by the deteriorating geopolitical situation, factor That as long as its effect is negative, it will reduce the potential for US interest rate hikes).
| The inflation forecast for the coming year in Israel is updated upwards to 2.3%
The rise in the global inflation environment during 2021 has largely relied on rising commodity prices in parallel with supply chain disruptions. All this while the opening up of economies and the expanding fiscal and monetary policies have provided significant support for accelerating demand.
The geopolitical deterioration following Russia’s invasion of Ukraine is fueling inflation on the part of commodity prices for fear of disruptions in energy supply and agricultural commodities. These concerns have led to a sharp rise in the spot prices of most major commodities, with the prices inherent for the coming year being considerably lower (about 20% oil, about 30% wheat, about 50% -60% gas).
The rise in commodity prices reflects a high risk premium, and if it is not a calm on the geopolitical level that moderates it, it will moderate following a global slowdown / recession.
Although the Israeli economy is characterized by relatively low sensitivity to energy prices, a factor that places it with low inflation compared to most countries in the past year, the recent rise in prices along with rising commodity prices leads us to update our inflation forecast for the coming year by 0.5%. 2% (1.7%) for an environment of 2% -2.5% (2.3%).
However and as in the world, the inflation mix does increase upward risk in the near term, but lowers the medium-term inflationary risk. Since inflation has so far been largely imported and in addition, developments so far in the labor market continue to reflect a rise in wages in line with the trend observed before the crisis and not characterized by significant inflationary pressures.
Thus, domestic inflation pricing continues to reflect a fairly high risk premium, and except for the coming year, which is characterized by high risk, we believe there is a preference for the shekel channel over the index. Expectations for the short term are around those in Europe, despite the Israeli economy’s relatively low sensitivity to energy prices.
Also, medium-term expectations hover around those in the U.S. despite the significantly higher inflation environment in the U.S., and despite the structural factors supporting the decline in the inflation environment in these ranges (mainly exchange rates and cost-of-living reforms that are expected to manifest during this period).
In terms of interest rates, the rise in medium-term inflation expectations to levels of over 3% in recent days supports a rise in April. However, it is important to note that beyond the Bank’s statements about a gradual rather than rapid rise in interest rates, the Bank of Israel has a higher room for maneuver than the Fed, given a more comfortable starting point for actual inflation and lower sensitivity to energy prices. .
Despite this, pricing in the interbank market has hardly been affected by developments in the world and in particular we have moderated expectations in the US and the eurozone, and it continues to move around 4-5 raises until the end of the year, and we estimate it is too aggressive at this stage. For the end of the year.
Also, despite the expectation of a significant interest rate hike in the coming year, the local curve continues to be characterized by exceptional steepness and is lagging behind the global flattening process, especially in economies where expectations of a high interest rate hike are relatively high. The current pricing in the domestic curve reflects a very high risk premium, so in a scenario where the deterioration in geopolitics degrades the world to a significant slowdown during the year, the potential for declining yields later in the year will become quite high.
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