Monday digest

Posted 4 September 2023

Overview: New school term has the US top of the class
Summer is officially over, but we are none the wiser regarding the direction of the economy. Or are we? Generally, the inflation backdrop continues to ease, although not fast enough for comfort according to Bank of England (BoE) chief economist Huw Pill. He wants interest rates to remain high and steady, and suggests policy should be kept steady at restrictive levels rather than sharp hikes followed by rate cuts. Pill argues the tight jobs market allows workers to push up wages which have previously been eroded by inflation, creating a dynamic that leads to inflation persistence. While Huw Pill may worry about the UK’s inflation persistence, the much more vibrant US economy would be far more likely to have a problem with sticky inflation as the labour market would remain tight. US bond yields may have fallen back recently on slight economic sogginess but we think it unlikely they will go too much further. Given the lag in economic dynamics in Europe and the UK, they have got more room to ease here.

So, are we any wiser at the end of months of seemingly economic procrastination, plateauing of interest rates, disappointing China news and fearing about imminent recession? Well, the general economic development has by and large withstood the monetary onslaught much better than expected while inflation has come down progressively. This tells us that despite widespread fears that after ten years of ultra-low interest rates, the return of ‘old normal’ levels of interest rates would spell imminent economic and market disaster are probably premature. As a result, markets have been much like the past summer months in the UK – not so hot but not disastrously cooler. Companies and households have been prepared for difficulties but it hasn’t been so difficult. Let’s hope the autumn is full of warmth, mists and mellow fruitfulness.

Life and debt: an era of high public borrowing 
At August’s conference in Jackson Hole, Wyoming, central bankers got existential. According to European Central Bank (ECB) President Christine Lagarde, worldwide trends toward tighter labour markets, regionalisation and the green transition have fundamentally changed the way monetary policy works. In her words: “There is no pre-existing playbook for the situation we are facing today – and so our task is to draw up a new one”. Something this playbook needs is a way to deal with significantly higher public debt piles. The hope was that government debts would come down once the world returned to ‘normal’ after the pandemic, but supply-side crises and acute inflation pressures have put a spanner in the works. The UK’s debt-to-GDP ratio is now above 100% for the first time since 1960 (when finances were still recovering from the Second World War), while the US is at a record high of 129% according to the US Congressional Budget Office.

Bringing these ratios down meaningfully in the next decade seems unlikely. Governments would need to run primary budget surpluses, requiring growth in tax revenues or lower spending – ideally both. Or an extraordinary growth spurt, which means debt/GDP naturally diminishes as GDP outgrows debt. Neither looks feasible. The World Bank now expects slower growth over the long term, and indeed, investor hopes of lower inflation are arguably predicated on such sluggish growth. Meanwhile, calls for public spending have gotten louder rather than quieter. Ageing populations (and electorates) in developed nations – which require larger healthcare and pension payments – and much-needed investment in the green transition make spending cuts look fanciful.

The UK is a prime example of these dynamics. We are all aware of the need for public spending, both as a long-term investment in Britain’s sluggish economy and as ongoing upkeep for critical services like health, social care and education. At the same time, growth prospects have been slashed, drastically lowering the expected tax base with which we can pay for such policies. Barring improbable tax reform, the only way to front the bill is extensive borrowing. But since this borrowing would already start from a high base, and much of it would be earmarked for things other than improving productivity, the government would effectively be resigning itself to indefinite debts.

Ultimately, populations will have to accept one or more of the following: persistently high inflation, stagnating living standards, or higher tax rates. The first is famously politically unstable, while we have seen over the last 15 years how the second can undermine liberal democracy. The third is the more realistic option, but it requires social cohesion and faith in the political system. That has been hard to come by in recent years across the US and Europe. This side of the Atlantic, where tax burdens are already relatively high, increased tax burdens will be a hard sell. In the US – where politics is so divided that a third of Americans think a civil war is coming – it may be impossible. Where monetary policy goes in this environment is hard to say. We can hardly blame central bankers for getting existential.

Emerging markets – if not China, India?
Emerging Market (EM) investors have had a stressful year. China has dominated the commentary once again, as it so often does, but this time with growth disappointment unwinding initial market optimism. But what about the other EM nations? China dominates both headlines and financial indices, but India in particular has had an impressive year. The narrowly-based Nifty 50 index has gained 10.3% over the last six months, despite the wider fall for EM equities. Exports of both goods and services have grown substantially (bucking the general global trend), while India’s government-led infrastructure push has helped demand and set the scene for better prospects ahead. The relative weakness of China, and Beijing’s increasingly aggressive attitude to its private sector, have also seen some reallocation of both trade and foreign investment. Near-term growth prospects are arguably better in India, and political restrictions have already led many Western investors to switch their preferred EM. Further improvements could mean India wins even more capital bound for its geopolitical rival.

That said, President Modi’s government has many of its own issues that could put off Western investors. This has not happened to a large degree yet, but India’s eagerness to keep trading with Russia is a definite sour note. There is also the question of China-India cooperation through BRICS summits. The collective of Brazil, Russia, India China and South Africa announced its expansion at its summit last week, inviting Argentina, Egypt, Ethiopia, Iran, Saudi Arabia and the United Arab Emirates — to join its ranks, and China and India agreed to remove troops from their disputed border. Strangely enough, after the US ramped up tensions with Beijing, it might be against India’s short-term interest to ease its own tensions with China.