Where are we in the economic cycle? The answer will have a key bearing for policy and on financial markets. At present it points to three peaks: peak growth last year, peak inflation this and peak interest rates next.
Global equity markets are already in a corrective phase, but UK equities may be relatively well protected as, by international standards, they and sterling are cheap. However, gilt yields will join global bond yields in heading higher.
Of the challenges facing financial markets, tighter monetary policy is the biggest concern. Additionally, there is uncertainty about where growth rates will settle post pandemic. Equally, while we may be past the worst of Covid, because much of the world is not vaccinated there is a risk that new variants may emerge.
The good news is that economies are recovering. After the collapse in 2020 it was no surprise that UK and global growth rebounded last year. Markets expect solid growth this year, too.
Normally towards the end of an economic cycle growth slows, inflation rises and policy tightens. The present juncture suggests we are in such a situation, but this is not a reason to be pessimistic for, as recent decades show, there are significant underlying structural forces contributing to a growing global economy.
Its size has increased from $32 trillion in 2000 to $63 trillion when the 2008 financial crisis hit and this year the world economy will reach $102 trillion. There is still much innovation, driven by the digital and data revolution, plus the size of the global middle class is growing. This underlying picture is a positive one.
Yet there are challenges. China's zero-Covid policy might yet trigger further disruptions to supply chains and weigh on growth prospects. Also, oil prices are trending higher. While initially this may feed inflation, in the past significantly higher energy prices have often been a harbinger of slower growth.
Also, before the pandemic, secular stagnation in the form of weak demand and low investment and growth was a problem facing many western economies. It is the latter that Britain and the European Union must confront.
After 7.5% growth last year, the UK may grow by 4.5% this year, not helped by the cost-of-living squeeze, and 2.4% next. Even though consumer prices inflation may peak at about 7% this spring, financial market inflation expectations have eased.
Of course, rising inflation has already triggered market concerns, having been the catalyst for tighter monetary policy.
Unconventional monetary policy has been with us since the aftermath of the global financial crisis. This acted as a shock absorber for the world economy and helped to underpin financial assets. It was given a further lease of life during the pandemic, alongside easier fiscal stances.
Cheap money in the form of low policy rates and quantitative easing has bred wider inflation worries, but its bigger problems have been to feed rampant asset price inflation and to generate a similar environment to that evident before the global financial crisis, with markets not pricing for risk.
Now, normalisation of monetary policies will vary, driven by domestic factors. China, for instance, after a prudent monetary policy last year, is easing, while Japan continues to be ultra-loose.
Elsewhere, when it comes to the likely tightening of monetary policy, financial markets need to focus on the three "S's": scale, speed and sequencing. The scale reflects how much tightening, with the US Federal Reserve likely to increase by 1% this year, but the Bank of England may move only from 0.25% to 0.75%, with further tweaks higher in 2023. The speed is expected to be gradual and predictable.
Financial markets will focus heavily on the sequencing between higher policy rates and quantitative tightening, as the latter threatens significantly higher yields. Already this prospect has triggered considerable recent volatility in financial markets, with the likelihood of further turbulence to come.
This article was published in The Times on 25 January, 2022.
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