The year began with worries about health triggering pessimistic views about the economic outlook. This was followed in the spring by strong upward revisions to growth forecasts, because of the successful rollout of vaccines in western economies, as well as China’s success in controlling the virus. These led to a focus on a strong rebound in the global economy.
Concern over the scale of President Biden’s fiscal boost in the US then materialised, and while it was not the only factor, it focused attention on the scale of reflation and whether this – along with the global economic rebound – would feed inflation. Then, through the second quarter, inflation fears rose and they still persist, while more recently concerns have emerged about the sustainability of the global recovery as, after the strong rebound this year, it is inevitable that growth will decelerate in 2022.
Despite market uncertainty, the underlying picture is one where global growth prospects have improved during 2021, and while the rate of growth worldwide will slow next year, western economies will have returned to their pre-crisis levels by the end of this year. Persistent inflation pressures, though, will necessitate some gradual monetary policy tightening.
Four key factors to consider
In addition to market valuations, it has been necessary to consider four key top-down factors: health, macro policy, economic data and geopolitics.
Of these, two still have the potential to result in extreme outcomes for the UK and global markets: health and geopolitics. Currently, markets are discounting a relatively favourable health outlook and are expecting a benign geopolitical picture. Health issues dominated the early months of this year. Then the successful vaccination rollout in western economies, plus the rebound in China, eased health worries and allowed governments like the UK’s to ease restrictions, thus allowing economic activity to recover.
However, we are seeing worries persist, with the World Health Organisation noting that last week saw the first global rise in virus numbers globally for some time, citing Brazil and Indonesia among others. In the UK, the combination of high numbers vaccinated plus relatively low numbers of hospitalisations and deaths is allowing further unlocking, but the increasing number of cases is still curbing the pace of opening up as well as affecting peoples’ confidence and behaviour, and in turn dampening the pace of the economic rebound.
When it comes to the economic picture and policy, the markets are displaying considerable uncertainty, too. This reflects that evolution from a focus on a strong rebound to worries about inflation and a possible future deceleration of growth.
The last week fits in with this and has been another important one for economic data and policy:
(a) US inflation rises
In the US, consumer price inflation (CPI) rose to an annual rate of 5.4%, much higher than the 4.9% expected by financial markets. This added to inflation worries. The monthly change for CPI averaged 0.2% or less for the four months from September to December, but has crept higher in recent months: 0.6% in March, 0.8% in April, 0.6% in May and 0.9% in June. This was followed, a day later, by US Federal Reserve Chairman Jay Powell, in testimony to Congress, making clear that they are vigilant to inflation concerns but do not need to change policy.
(b) As UK inflation rises, too
Also, in the UK there was a large rise in the annual rate of UK CPI in June, reaching 2.5% from 2.1% in May. The annual rate has trended higher since its recent cyclical low of 0.3% last November.
This inflation news was followed by speeches by two members of the Bank of England’s Monetary Policy Committee (MPC) indicating a more cautious tone than previously on the inflation outlook. For instance, Deputy Governor Dave Ramsden said inflation could hit 4% later this year (although he noted it did likewise in different circumstances in 2008 and 2011 before returning to the 2% target). This reflects a welcome shift, as previously, members of the MPC have been relatively quiet about building inflation risks.
Latest data also showed an annual rise to 7.3% in average weekly wages, although after taking into account distortions because of the pandemic, the Office for National Statistics stated that average earnings are rising between 3.2% to 4.4%. Even though the UK economy is recovering, concern about the virus may have contributed to a slower pace of growth in May, as recent data showed, with the economy growing 0.8% over the month compared with a rise of 2.0% in April and 2.4% in March. The UK economy is still 3.1% below its pre-crisis peak but it should, helped by further unlocking and an improvement in confidence, return to that peak after the summer.
The week finished with a report from the House of Lords Economic Committee putting quantitative easing (QE) under the spotlight, and rightly so. One of the many issues raised by the report was the need for the Bank of England to outline an exit strategy. Through this year the expansion of QE has not been justified as the economy has strengthened.
(c) Slower Chinese growth
The other key piece of economic news over the last week related to China, with market fears of a global slowdown being fed by evidence of a deceleration in China, where economic growth slowed – as expected by the market – from 18.3% in Q1 to 7.9% in Q2. Growth is expected to decelerate at an annual rate over the remainder of this year.
The central bank in China also eased policy through a reduction in reserve requirements, although that was largely to offset a draining of liquidity that would otherwise have taken place as previous lending facilities unwound. Nonetheless, with growth expected to decelerate over the second half of the year, it would not be a surprise if policy were to ease further, being targeted to help small and medium-sized firms.
Such data captured the financial market focus on inflation, policy and a possible slowdown. Of course, because of the scale of the economic collapse last year, economic data and forecasts need to be interpreted with greater caution than usual.
For instance, year-on-year comparisons are heavily distorted. Also, the scale of last year’s collapse plus uncertainties associated with unlocking mean that many market forecasts about economic data are no more than best guesses.
Costs are rising, but for how long?
In my view, the issue is whether this rise in inflation passes through quickly, persists for a year or two, or becomes permanently entrenched. Similar trends are evident in many countries, such as the UK and the US, with firms having to contend with rising costs of inputs and raw materials, including a surge in commodity prices.
There has been a considerable increase in transportation costs. Oil prices have risen steadily over the last year, and there is every likelihood that they could firm further in coming years. Much of this reflects the strong rebound in global demand, alongside supply bottlenecks. In addition, there is some evidence of higher wage pressures.
Firms appear able to pass on higher prices to consumers, too. Indeed, the flipside of the incredibly good earnings season just seen in the US, is the ability of firms to raise margins in the face of a rebound in demand. Whether this is sustained is where the debate lies.
In an interesting economic note earlier this week, the Federal Reserve Bank of San Francisco reminded us that in 2010, following the Great Recession, there was also a rise in commodity prices and in inflation expectations that led some central banks like the ECB to prematurely tighten policy because they feared second round effects. Others, like the US Federal Reserve, did not tighten and were proved right as inflation pressures eased in 2011.
In my view, this time, the rise in inflation may prove more persistent. With inflation rising there is a case for gradual, predictable and early policy tightening.
Despite that, the message that central banks – led by the Fed – are sending is that they will not tighten soon. They will keep a close eye on output gaps (that is their view of how much spare capacity there is in an economy) and on inflation expectations.
As economies are below pre-crisis levels, they feel they do not need to tighten policy and they also recognise that economies may be vulnerable to not only health risks but to premature policy tightening. That leads to where the focus of market attention currently is, driven by a focus on US policy as well as on global growth prospects.
Please note, the value of your investments can go down as well as up.
