A period of calm appears to have descended upon financial markets following the significant equity market adjustment witnessed in February. So where should the focus of attention be now?
Three broad issues appear relevant, which vary across markets and economies: valuations, economic performance and monetary policy. Important to all of these will be the inflation profile.
An opportunity to reassess
The equity market adjustment has provided an opportunity to reassess valuations. Previously we had expressed concern about valuations that appeared stretched, led by the US stock market, so in that respect the fall in share prices is a good chance to re-evaluate the market.
The economic story is a very positive one, with economic optimism appearing to be returning across multiple economies. Investment intentions are recovering. The pick-up in global trade, seen last year, has continued. The big question, though, is the impact it could have on inflation.
This is more of a concern in the US and UK than the euro area or Japan, where the central banks are likely to lag the actions of the US or UK.
The thinking at the Bank of England was captured by the comments from Governor Mark Carney at the press conference following the recent February Inflation Report: “The speed limit of our economy has gone down since the financial crisis… what’s relatively modest growth by historic standards means we put ourselves in a situation where inflationary pressures build.”
In a nutshell, even the modest to steady growth we are witnessing now will keep the Bank on its toes, prepared to pounce with tighter policy.
Inflation outlook is consistent, but may prove stubborn
The Bank’s February Inflation Report stuck with its previous view from November that inflation will decelerate this year. That is our view, too. Yet in the Inflation Report the Bank felt that the rise in oil prices could result in inflation falling more gradually in the near-term than previously thought. Indeed, after peaking at 3.1% in November, inflation has eased to 3% in each of the last two months.
In the six quarters since the EU Referendum the economy has grown at about the same rate as in the six quarters before the referendum. Since last September or so this has been helped by the stronger world economy, although that does not explain all the story. The economy has proved resilient.
Meanwhile, productivity growth in the last two quarters has been the highest since 2008 – a welcome development and suggesting that if demand is steady, then in a service sector economy productivity can hold up and recover. In some respects this allows the Bank of England time, but there is little doubt it has a bias to tighten.
The inflation path in the UK depends on external components driven by sterling, oil and import prices, and on domestic inflation pressures, too. In setting rates it is clear the Bank will keep a close eye on the latter, particularly unemployment and wages. The Bank’s view is that pay pressures will start to build, as slack is absorbed and the drag from unemployment on wage growth dissipates. The Bank’s agents also see higher pay growth. This fits with our thinking also. Despite this, it seems hard to envisage rampant wage or price pressures, as inflation expectations remain low, anchored around the Bank’s 2% target.
UK monetary policy still looks steady
In this UK environment monetary policy still looks like being gradual and predictable. But there is no doubt that more central banks are in the tightening phase.
Since the financial crisis equity markets have corrected on a number of occasions, only to recover, helped by the knowledge that monetary policy was accommodative. And while it is still accommodative in that rates are low, there is little doubt the monetary policy cycle has turned.
Naturally it varies across countries. This suggests that while calm has been restored to markets, there may be increased attention on inflation in coming months. Bond markets will be wary, while equity investors will be hoping the good news from the economy can propel them higher.
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