Three themes dominate currently:
- Policy rates staying higher for longer.
- Notwithstanding this, the ability for policy rates to fall from their current highs, as they find their new equilibrium.
I have highlighted these three themes for a while, and thus it is good to see that the direction of markets is consistent with them.
Western economies are heading into a disinflationary environment, of modest inflation and growth. I am hesitant to call it low inflation, as inflation may yet settle between 2% and 3%. Occasionally recently, and more so in the US than here, disappointing economic data, whether higher than expected inflation, or data suggesting some moderation in growth, has led to references of stagflation in which inflation is high, or growth weak.
Yet, since peaking in autumn 2022 inflation has trended down in the US, euro area and UK. Where it settles is still unclear, for reasons highlighted before. The market and central bank view is always that inflation will return to the 2% target but there is no guarantee it will, or reason that it should.
In their latest forecasts in April, the International Monetary Fund (IMF) pointed to growth rates this year and next of: 2.7% and 1.9% for the US; 0.8% and 1.5% for the euro area; 0.2% and 1.3% for Germany; 0.7% and 1.4% for France; 07% in each year for Italy; and 0.5% and 1.5% for the UK.
Recent economic data, interestingly, shows that the Citi surprises index, which measures where economic indicators are relative to expectations, is surprising to the upside in western Europe including the UK, but disappointing in the US. It may be that tight monetary policy and tougher financial conditions are slowing US growth, as evidenced by weaker than expected payrolls data and a fall in consumer confidence.
In addition, industrial activity, particularly manufacturing, remains weak in Germany while service sector activity across the euro area and the UK is much stronger in recent months. In fact, the IMF’s forecast for UK growth may already be too low, based on the 0.6% quarter-on-quarter GDP rise in Q1 and the NIESR pointing to a strong rise of 0.7% month-on-month in April.
The forecasts from the Organisation for Economic Cooperation and Development (OECD) have pointed to a similar story, of modest growth and low inflation. Their forecast for the OECD region (which covers the so-called more advanced economies, but it is an ad hoc grouping), points to 1.4% growth this year and 1.5% next. The OECD sees US growth as being above this OECD average in each year, while the major European economies are below. But it may be the case that the UK and euro area prove stronger, as inflation falls and if monetary policy is eased.
Importantly, the two factors that triggered higher inflation in recent years have been corrected. These are lax monetary policies and supply-side shocks, and the ending of the latter has allowed energy prices and supply-chain pressures to ease. Indeed, tighter monetary policy works and has contributed to the deceleration of inflation. But, as we have noted previously, despite decelerating inflation, consumer prices are high.
Take the UK as an example. In the first quarter of this year prices were 21.2% higher than three years ago. Moreover, what I would call “the Bank of England penalty” is that prices are one-seventh higher than they need otherwise have been. That is, prices are 14.2% above where they would have been if the Bank of England had ensured that inflation had risen in line with the target of 2% over those three years. So, while inflation is decelerating, it is important to recognise both the squeeze that higher levels of prices are still having and also that tight financial conditions are still impacting wider business conditions.
Although interest rates need to settle at a higher level than pre-pandemic, this does not rule out the scope for them to be cut from present levels. There is still potential for policy rates to trend down, from June onwards in the euro area and UK and into the second half of this year in the US, euro area and UK.
This will likely then lead to a focus on where rates need to settle – and one of several structural issues impacting markets, as one looks ahead. These are expected to be the main structural issues:
- The future equilibrium level for interest rates.
- The debt overhang, although this will be partially helped by modest growth in nominal GDP allowing debt to GDP levels to stabilise, or improve temporarily.
- Another is geopolitics. There are many scenarios here. The general debate in recent weeks gives a gauge as to how complex these might be. For instance, the south and east China seas (with a recent focus on the Philippines and China), or concern about the Baltics in the wake of the US election. It is hard to quantify fully geopolitical risks but in qualitative terms this will reinforce a flight to safe-havens and the factoring in of risk-premia into energy, and perhaps some other commodity prices.
- Domestic politics, particularly in the UK and US. The issue of elections has been a dominant one already this year and we will return to the economic and financial implications of the UK and US elections.
- The ongoing shift in the balance of economic power to the IndoPacific, which in turn translates into the relative decline of western Europe, including the UK, in terms of global GDP.
We will return to these strategic issues in coming weeks. For now, the focus of markets is on the triggers for cuts in policy rates.
Please note, the value of your investments can go down as well as up.
