The start of the year has highlighted the complex interaction of factors impacting the financial market outlook, in the UK and globally.
Valuations apart, the interaction between health, economics, policy and politics remained dominant, as it has done since the pandemic began. The main current issue being the ending of the health crisis, and the timing and scale of the economic recovery. After a deep recession last year, the UK and world economy look set to rebound strongly in the second half of this year.
A return to growth, but a lasting pandemic legacy
This rebound potential was captured in the International Monetary Fund’s latest economic projections in January. Their main scenario makes sense.
The IMF now believes the world economy contracted by 3.5% last year. This was less severe than the 4.4% drop that they expected last October, largely because more economies unlocked in the third quarter. Lockdowns, as well as the wider impact of the virus, explained economic performance last year.
The IMF now sees the world economy rebounding 5.5% this year, before moderating to growth of 4.2% in 2022. After 2020’s deep recession, this would represent a strong rebound. Significantly, however, and not surprisingly, the scale of the overall shock means that even by next year, around 110 countries will have per capita incomes below their 2019 levels. The pandemic will leave a lasting legacy, with poorer communities hit hardest.
It is only once we have recovered from the health crisis that we can overcome the economic crisis. Consider the situation in the UK.
A justifiable lockdown, yet an unequal recovery
Health concerns, reflected in the grim total death toll, have justified the tough lockdown we are currently in. Data shows infections have fallen sharply from their recent peak. Based on prior experience, this means hospital admissions and then deaths will decline. Additionally, the rapid and impressive pace of vaccination should improve this outlook further.
These factors strengthen the case for an early phased unlocking, say from March. But against this rationale are the high levels we are at, how much capacity the health system has in which to cope, the emergence of new variants and the issue of how people might be expected to behave.
Naturally, one can understand the difficulty of making decisions around unlocking, but it seems fair to assume that the second quarter (April to June) will witness much greater economic activity as unlocking occurs.
Even so, social distancing is expected to remain in place in some form for some time. Thus, a number of sectors will remain moribund. As one example, August’s Edinburgh Festival Fringe, the biggest such arts event in the world, has already been cancelled.
The UK economy will bounce back strongly this year. Consumer spending could benefit from the high savings ratio, and business investment from healthy corporate profits. But not all areas will recover quickly. Unemployment is set to rise further, and many small firms will emerge from the pandemic with high debts. The economy is unlikely to return to pre-crisis levels until the first quarter of 2022.
Coming up: a challenging Budget
Attention will additionally focus in the next few weeks on the policy stance. The Prime Minister and Chancellor are expected to outline their economic message later this month: skills, innovation, infrastructure and the green agenda are expected to figure prominently.
Increased infrastructure spending will be an important part of the levelling-up agenda. Meanwhile, the green agenda will impact policy more, with the UK pushing its green credentials as it hosts the G7 meeting this summer in Cornwall and the COP 26 environmental meeting in Glasgow in November.
The early March Budget is a challenging one. The messaging will be clear. The fiscal position has helped the economy weather the crisis. The budget deficit is sizeable, with debt to GDP above 100%. The aim is to reduce the deficit without derailing the recovery. The fragile state of the economy points to the need to avoid premature fiscal tightening. Low inflation, rates and yields are keeping debt servicing costs low, giving room for fiscal manoeuvre. The policy focus should be on growth, with economic recovery then allowing debt to GDP to fall steadily, over time.
However, the Chancellor will be weighing up additional influences linked to the political economy. With a general election due in the summer of 2024 he may favour some additional fiscal tightening now, both to gain voter support for taking action on the budget deficit and to limit the risk of having to tighten policy closer to the time of that election. Also, he may recognise the sensitivity of the fiscal numbers to higher rates. While policy rates are low now, at 0.10%, they were 0.75% as recently as the time of the last Budget.
A fine balancing act
The economic environment suggests no need for current fiscal tightening. The political context appears to rule out spending cuts and manifesto commitments limit many tax changes. Of what remains, the conjecture is that the Chancellor will signal increases in corporation and capital gains tax.
Ahead of this pandemic the UK’s maturity of its outstanding debt was long, around 16 years. This left the UK’s servicing costs less vulnerable to shifts in market sentiment. On a separate point, the UK’s large current account deficit and movements in sterling have always left it exposed to global market trends (or to the comfort of strangers, as it has been called).
During this pandemic, though, the UK’s maturity of debt will have fallen sharply, largely because, like other major economies, the UK has seen large scale buying of new debt issuance by the central bank.
One way to view this, as we have alluded to before, is we are now witnessing unconventional monetary and unconventional fiscal policy and strong interaction between them. This adds considerable uncertainty to the future policy stance, including the sequencing, speed and scale of exit strategies. That is, after the amount of monetary and fiscal stimulus witnessed, how will policy revert to normal, over what timeframe and how can this occur in a way that does not destabilise growth?
The Bank of England has just left policy unchanged, with rates at 0.1% and the scale of Quantitative Easing (QE) at £875 billion and corporate bond buying at £20 billion. They gave mixed signals on future policy at the release of their quarterly Monetary Policy Report. Significantly, they indicated that were they to tighten they would now do it first by reversing QE (through selling gilts) before hiking rates. Previously they had said when they tightened they would raise rates to 1.5% before reversing QE. That is a key change.
However, for the moment there is no need for policy to shift. Indeed, the Bank still has about £150 billon more buying of gilts to make to hit their QE target and at their current rate of buying they will achieve that before year-end.
The Bank’s Monetary Policy Committee has also given mixed signals recently on negative interest rates, and that option of negative rates is to now be part of their policy toolkit from this autumn. By then, the economy is expected to be recovering solidly, even on the Bank’s forecasts, suggesting such a policy move will not be needed. Indeed, it is more likely policy rates stay low, and unchanged for some time.
A focus on trade
Naturally, the markets have been focused on the UK’s future trading relationship with the EU and its sector impact and will likely focus on the terms of the memorandum of understanding on financial services that the UK and EU are currently discussing. Sterling, meanwhile, although above previous lows, remains very competitive, and helpful for economic rebalancing.
Global Britain is an important part of the UK’s messaging this year. Markets are trying to determine whether that means a new economic direction. The UK has applied to join Asia’s regional trade pact. That makes sense. Twelve nations signed the Trans Pacific Partnership (TPP) in 2016, then President Trump withdrew the US from it, so the remaining eleven signed the Comprehensive Progressive Agreement for TPP, the CPTPP, and it is this that the UK wishes to join.
Japan, Canada and Australia are among its members. The hope is the US will rejoin, helping the UK’s aim to cut a trade deal with the US. Of course, one does not need a trade deal to trade, and regardless of such deals, one needs to have goods and services that the rest of the world wishes to buy. The benefits of such deals, naturally, are on helping remove tariff and non-tariff barriers, helping to facilitate trade.
This backdrop for markets appears constructive, in the sense that it is possible to see an exit from the pandemic and strong economic growth in the UK and globally. Bond yields, meanwhile, face the likelihood of greater volatility in inflation while longer term inflation expectations and current policy rates remain low. Markets, though, will want confirmation in coming months that we are moving from overcoming the health crisis to addressing the economic crisis.
Please note, the value of your investments can go down as well as up.