First, some context is needed, and this draws upon issues that we have talked about here through this year as we have begun to emerge from this pandemic.
During the space of the last six months the focus of markets, and in turn of economists, policy makers, investors and savers, has evolved from:
- initial optimism about the combination of the vaccine rollout and emergence from the worst phase of the pandemic
- concerns about rising inflation fears, partly because of supply bottlenecks, rising energy costs and lax monetary policies
- a renewed focus about a deceleration in growth, as rising costs and inflation squeezes spending power and dents confidence now, and as exit strategies from unconventional monetary and fiscal policies challenge post-pandemic growth prospects.
Currently, a combination of all the above is reflected in present thinking and market pricing.
The world and UK economy is rebounding from the pandemic, but inflation will be higher, exit strategies from cheap money and relaxed fiscal policies will be needed and growth will decelerate during 2022 and 2023.
This seems like the most likely path ahead – but how much growth will slow, inflation possibly rise and fiscal and monetary policies tighten is all up for debate.
Before focusing on each of these, it is important also to reiterate that the current cyclical rebound and rising inflation have to be judged within the context of structural changes impacting the economic outlook. These include the dominant trends that were evident before the pandemic hit, and which will be evident post Covid, namely the digital and data revolution and the shift in the balance of power to the IndoPacific region that includes India, China, Japan and the US.
To these, the post pandemic world will likely see more redundancy built into supply chains, as well as already leading to a renewed focus on the green agenda. Both of these may feed rising cost pressures.
The disruption caused by the pandemic has been huge. Yet the collapse caused to the world economy has been reversed already in a number of major economies such as the US and China. The US, for instance, returned to its pre-crisis level earlier this year. The UK, meanwhile, looks set to reach its pre-crisis level of activity before the end of this year.
The question then, is what will happen to future growth rates? In China, for instance, which was the first major economy to rebound from the pandemic, growth has slowed considerably and has not been helped by current property sector problems and by the energy crisis that is causing power cuts and restricted energy supply.
Globally, and in the UK, after the strong post-pandemic growth rebound this year, the pace of growth will decelerate next year although it will still be above pre-crisis rates of growth before slowing still further in 2023. By then, trend rates of growth are expected to be similar to those experienced pre-pandemic.
Costs are rising. There is, though, a need to differentiate between energy-linked commodities, where prices including oil remain firm, and other commodities, whose prices were softer recently in anticipation of a future cyclical slowdown.
The pandemic, meanwhile, has seen huge disruption to supply-chains, which has pushed transportation costs up. These disruptions to supply and hikes in transport costs should unwind as we emerge fully from the pandemic.
In terms of inflation, the issue is which ‘p’ the current rise will prove to be: pass-through, persistent or become permanent? We would agree with most central banks’ assertion that inflation is transitory, that the present rise is not permanent. There are many longer-term trends, including intense global competition and new technology set to keep inflation in check.
However, the likelihood is that the rise in inflation will persist, and not pass-through quickly, reflecting the rebound in demand, supply bottlenecks and higher costs, rising wages, the ability of firms to pass on higher costs or to simply boost their margins and, as a result of this, an increase in inflation expectations.
One of the big focuses, therefore, will be on exit strategies from cheap money and relaxed fiscal stances. In the UK, there are two major fiscal events in coming weeks: the Comprehensive Spending Review followed by the Budget, both following through on a relatively tough fiscal stance after the significant easing and help provided over the last year.
In terms of exit strategies, the issue is whether it will be tapering or tightening?
The US Federal Reserve has made clear its intention to exit via tapering by reducing the amount of assets it buys. On Friday, September’s data showed a rise in non-farm payrolls of 194,000 and a fall in the unemployment rate to 4.8%. This is consistent with recovery, although employment is still below where it was pre-pandemic, and this employment gap is watched closely by Fed Chairman Jerome Powell. Financial markets have already factored in this Fed policy, with rate hikes being delayed for some time.
In contrast to the Fed, which has helped guide market expectations, the Bank of England has been reactive, lagging the market. Effectively, UK markets have already tightened policy, factoring in higher rates over the next year.
Tapering should have occurred in the UK some time ago, with the Bank draining liquidity, as the Quantitative Easing (QE) strategy has not been justified based on the recovery in growth and rising costs and inflation. The Bank, though, did not drain liquidity when they should. Their preference is to exit not via tapering like the US, but via tightening through higher policy rates.
The forthcoming meetings of the Monetary Policy Committee (MPC) are November 4th, December 16th, February 3rd and March 17th. The market, currently, thinks rates will rise by the time of the February MPC meeting and that there is a one-in-four chance of higher rates at the November meeting. The MPC has been timid to date, and at the last meeting voted 9-0 to keep rates unchanged at 0.1% and 7-2 to keep printing money via QE.
A hike in November could be more of a possibility than the market expects; and then the question is not just when they hike but by how much. For instance, should they raise policy rates from 0.1% to 0.25% or from 0.1% to 0.5%, or wait until a subsequent meeting? At the time of the November meeting the Bank will face conflicting pressures: the economy will still be recovering, but costs will be higher, threatening to squeeze spending, while inflation challenges will persist.
Not that the actions of other central banks will influence them directly, but the tightening process that is already underway across a number of other countries is indicative of how the global mood is changing. The Fed will taper, the Bank will tighten, and the markets are pricing in this exit strategy.
Please note, the value of your investments can go down as well as up.