UK inflation surprises on the upside in August

Chris Scicluna
Emily Nicol

Soft US CPI lowers bond yields but Wall Street also closes weaker; Asian bourses follow today, with data in Japan and China falling short of expectations as delta weighs
A weaker than expected US CPI report – with the 0.1%M/M lift in core prices the least since February – led to a sizeable rally in the US bond market yesterday, with lower prices for the likes of used cars and rental vehicles supporting the Fed’s contention that recent price pressures had indeed been temporary. But declines in prices for hotel stays and airfares also hinted further at some impact on leisure activity from the rise in delta-variant virus cases. Therefore, while the 10Y UST closed down 6bps at 1.28%, an initial post-CPI rally in the equity market proved very short-lived, with the S&P500 closing down 0.6%. Of course, coming after a disappointing August payrolls gain, the CPI data further lowers the prospect of the Fed announcing the start of the QE taper at next week’s FOMC meeting.

US equity futures have since firmed fractionally, with the status quo retained after California’s Democrat Governor Newsom won the backing of about two-thirds of electors in a recall election. However, the overnight losses on Wall Street have weighed on Asian markets today, with some disappointing local data not helping matters. In Japan, where the July machine orders and services activity reports underwhelmed and the September Reuters Tankan survey pointed to softening of business conditions, the TOPIX has declined 1.1% today. In political news, Taro Kono’s leadership aspirations received another boost with mooted candidate Shinjiro Koizumi endorsing him as “…the leader to breathe new life into the party and to change both the LDP and Japan”.

In China, today’s data dump pointed to an even greater than predicted slowing of activity in August – especially retail spending – following a local virus outbreak. And so with another virus outbreak leading to lockdowns in China’s Fujian province, the CSI300 has declined 1.0% today. In other Chinese news, while the PBoC is providing more liquidity to help boost the economy, today’s one-year medium-term lending facility operation was again conducted at an unchanged interest rate of 2.95%. Meanwhile, the Hang Seng fell 1.6%, with China reported to have revised banks that China Evergrande will not be able to make an interest payment scheduled for next Monday. By contrast, stocks rose modestly in South Korea, where the jobless rate fell unexpectedly in August to a record low of 2.8%. While generating plenty of headlines and political outrage, there was little market reaction to news that North Korea has conducted a further missile test, with two ballistic missiles into waters off the eastern coast.

In the Antipodes, Australian stocks declined modestly despite a partial rebound in the Westpac consumer confidence index in September, while the 10Y AGCB yield fell 4bps to 1.21, dragged lower by the rally in USTs. Kiwi bond yields also fell ahead of tomorrow’s Q2 GDP report, which is likely to report robust growth, but since unwound temporarily by the recent virus outbreak.

Japan’s core machine orders rise less than hoped in July; service sector activity contracts unexpectedly in July and the Reuters Tankan points to softer business conditions of late

Today’s Japanese official sector data flow kicked off with news on machine orders for July. Slightly disappointingly, core private domestic orders (which excludes volatile items such as ships and capex by electricity companies) increased a smaller than expected 0.9%M/M, while the waning influence of base effects meant that annual growth slowed to 11.1%Y/Y from 18.6%Y/Y previously. In better news for exporters, total machinery orders increased by a much larger 11.7%M/M, in large part due to a 24.1%M/M rebound in foreign orders (more than double last year’s pandemic-depressed level). A 14.0%M/M increase in government orders (up almost 29%Y/Y) also boosted total orders. Within the detail, perhaps unsurprisingly, orders from the private manufacturing sector were comparatively robust, increasing 6.7%M/M in July and so up more than 32%Y/Y. Some of the lift stemmed from the volatile shipbuilding industry, where orders increased more than 57%M/M. However, by far the largest contribution came from the electrical machinery industry, for which orders rebounded strongly to the highest level since 2008. By contrast, core orders from the private non-manufacturing sector fell 9.5%M/M in July and so were down 5.3%Y/Y, with weaker orders reported in every industry aside from real estate and ‘other non-manufacturing’. Given today’s result, core machinery orders are tracking 2.3% above the average through Q2 – a positive outcome to be sure, but to date far below the 11%Q/Q growth that firms had forecast for Q3.

In other news, METI’s Tertiary Industry Activity Index revealed 0.6%M/M decline in service sector activity in July, disappointing the consensus estimate that activity would build on the rebound reported in June (the latter revised down fractionally to 2.2%M/M). Activity was up 2.0%Y/Y, reflecting the very weak base created by the early stages of the pandemic, but was still 4.7% lower than in February 2020. In the detail, unsurprisingly, the decline in activity was led by non-essential personal services, which decreased 0.9%M/M and so was more than 15% lower than in February 2020. Activity related to essential personal services fell just 0.2%M/M, while activity related to business services edged up 0.2%M/M. By industry, perhaps assisted by activity associated with the Olympics, the largest increase was a further 5.5%M/M rebound in activity related to living and amusement services, which nonetheless remained more than 22% lower than in February 2020. The largest contributions to the decline were made by a 2.5%M/M decline in medical and welfare activity, a 2.5%M/M decline in retail trade and a 2.4%M/M decline in activity related to transport and postal services. Given today’s result, the level of service sector activity in July was 0.2% below the average in Q2. But in light of developments in virus cases since July, data over the remainder of the current quarter might prove less benign.

On that score, in common with last week’s Economy Watchers survey, today’s Reuters Tankan survey pointed to a recent softening of business conditions in both the manufacturing and non-manufacturing sectors. Indeed, after last month rising to the highest level since January 2018, the overall diffusion index (DI) for manufacturers slumped 15pts to 18 in September – still very positive compared with the long-term average (which sits around zero), but nonetheless the lowest reading since April. The forecast DI – which measures expected business conditions three months ahead – fell 12pts to 19, indicating that respondents expect business conditions to remain broadly similar in the near term. Given the widening of restrictions on activity in the retail and hospitality sector, the overall non-manufacturing DI fell 7pts from last month’s pandemic era high to -2, which in contrast to the manufacturing index lies below the long-term average (which is around 5). The forecast DI fell 6pts to 7, which still indicates that firms expect some improvement in business conditions over the next three months (presumably once vaccination progress allows pandemic restrictions to eased). At the industry level, in the manufacturing sector, the decline was reasonably broad-based, but a 48pt slump in the autos and transport DI to a 10-month low of -14 was of particular note (likely reflecting a combination of supply bottlenecks and pandemic-related restrictions on output and demand). Aside from the auto and textile/paper industries, all industries continued to describe business conditions favourably. Within the non-manufacturing sector, the DI for retailers slumped 33pts to a three-month low of -22. However, the ongoing pandemic reinvigorated optimism in the information services industry, with the DI climbing 23pts to a three-month high of 50 – now once again the most optimistic industry across the survey.

China’s activity indicators for August all weaker than expected, especially retail activity; home price inflation slows too
Turning to China, today saw the release of the country’s key domestic activity indicators for August, together with home price data for the same month. Unfortunately, all of these releases pointed to a greater slowdown in growth than analysts had expected, especially as regards retail spending, which doubtless mostly reflects the virus outbreak that begun in late July and which led to curbs in activity across a number of major cities during August. This finding is consistent with the sharp weakening of the service sector PMI indexes in August, and so perhaps should have been anticipated by the market.

Beginning with the factory sector, annual growth in industrial output slowed to 5.3%Y/Y from 6.4%Y/Y previously, which was 0.5ppt below the consensus expectation and the slowest pace of growth since July last year. For the year to date, industrial output increased 13.1%Y/Y, but this follows pandemic-impacted growth of just 0.4%Y/Y a year earlier. In the detail, while mining and quarrying activity grew at a faster pace of 2.5%Y/Y, growth in power generation slowed considerably to 6.3%Y/Y from 13.2%Y/Y in July. Meanwhile, activity in the manufacturing sector grew just 5.5%Y/Y, which was down from 6.2%Y/Y in July and 8.7%Y/Y in June. On an industry basis, unsurprisingly, the standout remained pharmaceuticals, where a 32.9%Y/Y lift in output was up from 25.3%Y/Y in July. By contrast, the smelting and processing of ferrous metals fell 5.3%Y/Y – doubtless contributing to recent fall in the price of iron ore – and production of autos declined an even steeper 12.6%Y/Y. Growth in production of other transport equipment also slowed to just 1.3%Y/Y, but growth in production of machinery and general equipment was steady at 10.3%Y/Y and growth in production of ICT equipment picked up slightly to 13.3%Y/Y.

Turning to the demand side of the economy, growth in retail spending slowed 6.0ppts to an 11-month low of 2.5%Y/Y in August – a substantial 4.5ppts below the consensus expectation and down from as much as 12.1%Y/Y as recently as June. For the year to date, retail sales increased 18.1%Y/Y, but this comes off the back of an 8.6%Y/Y decline a year earlier. Whereas spending on catering services had increased 14.3%Y/Y in July, it fell 4.5%Y/Y in August. Growth in spending on goods slowed to 3.3%Y/Y from 7.8%Y/Y previously. Spending on apparel fell 6.0%Y/Y (it had grown 7.5%Y/Y in July), while spending on household appliance fell 5.0%Y/Y (up 8.2%Y/Y in July). Spending on communications equipment and autos fell 14.9%5Y/Y and 7.4%Y/Y respectively. Meanwhile, growth in investment spending on non-rural fixed assets declined 1.4ppt to 8.9%YTD/Y in August, which was 0.1ppt below the consensus expectation. Growth in private sector investment slowed 1.9ppt to 11.5%YTD/Y, whereas growth in state investment slowed just 0.9ppt to 6.2%YTD/Y. Manufacturing sector investment grew at a faster pace of 15.7%YTD/Y, but this was down from 17.3%YTD/Y in July and follow an 8.1%YTD/Y decline a year earlier. For those where the breakdown was available, slower growth was observed across almost all industries in the manufacturing sector. Property development increased 10.9%YTD/Y, which was down from 12.7%YTD/Y in July and a little below market expectations. Finally, despite the interruptions to activity, the urban unemployment rate was steady at 5.1% in August.

In other soft Chinese news, new home prices across China’s 70 largest cities increased 0.16%M/M in August, marking the smallest increase since December last year. As a result, annual growth in prices slowed 0.4ppt to 3.7%Y/Y. Existing home prices were essentially unchanged in the month causing annual growth to slow 0.4ppt to 2.9%Y/Y. As in previous months, price pressure is more prevalent in so-called first-tier cities, where new home prices increased 0.4%M/M in August. However, this was also an eight-month low, led by a sharp slowing in upward pressure in Beijing – which had been affected by the virus outbreak – and a slight decline in prices in Guangzhou. Prices for new homes in third-tier cities increased less than 0.1%M/M, while prices for existing homes fell 0.1%M/M for a second consecutive month.

UK inflation surprises on the upside in August, but sources of increase do not point to persistent pressures
Having fallen sharply in July, the UK’s inflation rate took a notable step up in August and by a larger than expected 1.2ppts to 3.2%Y/Y. While this was the largest monthly rise inflation since the series began in 1997 and the highest annual rate since March 2012, the jump largely reflected base effects associated with last year’s hospitality subsidies and VAT cut, which will ultimately prove temporary. Indeed, the rise in consumer prices on the month (0.71%M/M) was merely the strongest for August since 2018.

Within the detail, due to the base effect associated with last year’s hospitality subsidies and VAT cut, restaurant and hotel prices were up 8.5%Y/Y in August, a rise of 6.5ppts from July and by far the strongest rate since the series began. Recreation and culture inflation was also pushed higher by a rise in computer game prices which are often highly volatile depending on which games are most popular in any single month – inflation of games, toys and hobbies was up 6.7ppts on the month at 3.8%Y/Y. And there was another notable contribution from the transport sector as – mimicking the recent pattern in the US – the annual increase in prices of second-hand cars accelerated to 18.3%Y/Y, the most since February 2010, reflecting increased demand amid supply bottlenecks impacting production of new autos. Overall, non-energy goods industrial inflation jumped 0.9ppt to 3.3%Y/Y, matching the series high recorded at the start of 2010, while services inflation leapt 1.4ppts to 3.0%Y/Y, the highest for more than four years. So, with energy inflation having moved broadly sideways in August and food inflation up 0.9ppt to 0.9%Y/Y, core inflation also surged last month, by 1.3ppts to 3.1%Y/Y, the highest since November 2011.

UK inflation also rose further at the producer level, with output price inflation up 0.8ppt in August to 5.9%Y/Y, the highest since November 2011. Some of the rise was due to higher petrol price inflation, which accelerated more than 4ppts to 50.4%Y/Y. But the source of the largest contribution to the rise on the month was the “other manufactured goods component”, with wood, cork, straw and plaiting materials the principal driver. Meanwhile, despite a slight easing in crude oil inflation due to base effects, the input PPI rate also increased further, up 0.6ppt to 11.0%Y/Y, with prices of iron, steel and ferro-alloys the main source of upwards pressure with wood prices similarly adding upwards pressure.

Looking ahead, the inflation outlook in the UK remains highly uncertain. Services and manufactured goods inflation are likely to move somewhat higher over the near term due to base effects. And with the energy component set to rise again in the final quarter not least due to Ofgem’s increase of more than 12% in the regulated price cap for household energy bills from October, we expect the headline CPI rate to take a further step up before the end of the year, peaking at around 4%Y/Y. Inflation will remain elevated for much of the first half of 2022. But while household energy bills could well add additional pressure further ahead, base effects should largely fade. And with still few signs of increased producer goods prices being passed on to consumers beyond the energy sector, and wage settlements unlikely to accelerate significantly at the aggregate level, we continue to expect the headline CPI rate to fall back close to and eventually just below 2.0%Y/Y in the second half of the year. Given the risks that skill shortages pose to wage growth, we acknowledge that the risks to the inflation outlook are skewed somewhat to the upside. But the imminent ending of the government’s furlough scheme could well have a dampening effect. And we think that this morning’s market pricing of two BoE rate hikes next year is overdone.

Euro area IP data to confirm return to manufacturing growth in July; French final inflation data for August align with flash estimates
This morning will bring euro area industrial production figures for July. Following last week’s release of national data, which reported growth in the three largest member states and significant expansion in Ireland, we expect industrial production (excluding construction) to have risen by 1.1%M/M to be up 6.6%Y/Y and 0.3% above the Q2 average. Euro area labour cost data for Q2 are also due. Separately, like the respective German and Spanish numbers, final French inflation this morning confirmed the reported increase in the preliminary release showing that the EU-harmonised HICP measure rose 0.9ppt to 2.4%Y/Y, reflecting a rebound in non-energy industrial goods inflation linked to the end of the summer sales – indeed, on the national measure, headline inflation was up 0.7ppt to 1.9%Y/Y, with core inflation up 1.1pts at 1.4%Y/Y, the highest for more than nine years. The equivalent Italian figures (due shortly) are similarly expected to align with the flash estimate that reported an increase of 1.6ppts to 2.6%Y/Y.

In the US attention turns mostly to the factory sector today
In the US, today attention turns from inflation to the factory sector with the release of the IP report for August and NY Fed manufacturing survey for September. Regarding the former, Daiwa America’s Mike Moran expects a 0.7%M/M increase in output, with employment gains pointing to a lift in activity in the manufacturing and mining sectors and above-average temperatures likely lifting output in the utility sector. For those investors hankering for more inflation data, the BLS will report developments in import and export prices during August.

Australian consumer confidence rebounds modestly in September
Following yesterday’s indication in the NAB Business Survey of a lift in perceived business conditions, today the Westpac consumer confidence survey indicated that consumers are also beginning to see light at the end of the tunnel, notwithstanding the ongoing lockdowns in New South Wales, Victoria and Canberra. After declining 4.4%M/M last month, the headline index increased 2.0%M/M to 106.2 in September – above the long-term average – led by increased optimism about both the near- and medium-term outlook for the economy. The improvement in confidence doubtless reflects accelerated vaccination progress – more than 70% of adults in New South Wales adults will be fully vaccinated by early October – which is expected to allow restrictions to begin to be eased somewhat over the coming month or so.

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