Monday digest

Posted 14 June 2021

Overview: Central banks return to the spotlight

The G7 meeting, held in Carbis Bay in St Ives, was the centre of attention last week, even if markets were still getting to grips with the earlier announcement from G7 finance ministers about the proposed Global Minimum Corporation Tax. While the announcement itself had little impact on share prices, we suspect the tax will keep gaining momentum. Progress might be slow, but corporate tax rises – particularly for those multi-nationals that have been avoiding tax – do not look like going away.

Market attention is now fixed firmly on monetary policy as we head into another round of important central bank meetings – just as investors have been revising growth expectations slightly downward, while inflation readings have been ramping up – as expected. When the European Central Bank (ECB) opted last week to increase the pace of bond purchases, it stayed relatively tight-lipped about its rationale. The market is pretty sure quantitative easing volumes will be increased only for a short period, probably slowing into the Autumn. While the ECB’s decisions were described as unanimous, we suspect the discussion may have been less straightforward. It appears that all central banks are now focused on employment and wages, especially in service sectors. Here, the ECB and the rest are in no doubt – labour needs to have more pricing power – most likely in order to stimulate and stabilise broad consumer demand.

Meanwhile in the US, core consumer price index (CPI) inflation stepped up to 3.8% year-on-year, 0.3% more than anticipated. Bond yields rose briefly to 1.53% after the release and then pushed down again to end the week at 1.45%. Arguably, investors are toning down their previous stratospheric economic growth expectations, amid discussions about smaller infrastructure fiscal packages. However, most of the US bond yield decline could be attributable to a decline in “term-risk premium”, the estimated excess return in holding ten-year US Treasuries in comparison to cash. The term-risk-premium seems to have come down mostly because investors have become less worried about the US Federal Reserve (Fed) losing control of inflation – and thus future bond yield increases – and have decided to go back to a more neutral duration. It also goes hand-in-hand with the current decline in equity market volatility.

With the threat of higher yields having dissipated, for now, markets may well stay as calm and Goldilocks-like as they have been since mid May. But at the same time, the growth fantasy rocket fuel that propelled them upwards since the autumn of 2020 is likewise dissipating. It would take a meaningful change in the economic recovery narrative or central banks’ stance to upset this ‘wait-and-see-but-remaining-quietly-confident’ market attitude. Of course, one such catalyst would be a more aggressive COVID-19 variant, which may well be developing right here in the UK. So far, rising case numbers have not been matched with a similar increase in hospitalisations. Should this continue, UK growth expectations (and beyond) may get another boost. The next few weeks will be crucial in this respect, so despite the warm weather’s distraction potential, we will keep a very close eye on the implications of the latest virus developments in the UK to global growth projections.

Are markets entering a crucial key transition phase?
Change is in the air. The cyclical shift which began last Autumn has waned recently. Sectors with a high exposure to global growth, like real estate and energy, have fared well over the last month – but then so too have tech-driven companies geared for the long-term future. The S&P 500’s financial companies declined -0.24% over that period, while the information technology index saw a 0.7% gain. Last week confirmed the continued mixed signals. Healthcare, considered a highly defensive investment, was the big winner over the last few days, with the index jumping 1.7%. But real estate also leapt, up 1.5% for the week. These are very short-term moves, but they paint the picture of a market that is unsure what it thinks.

Looking outside of the equity market gives a bit more of a clue of investor expectations. The ten-year yield on US Treasury bonds has been trending downward, and breakeven rates – a measure taking inflation into account – have plateaued or rolled over. Longer-term inflation expectations (five to ten years) have never quite made it to the levels seen post the global financial crisis, so there is currently little evidence in the market pointing to the economy overheating on a lasting basis.

We are clearly in a transition phase, and markets – just like the global economy – are still finding their rhythm. Everyone expects strong growth in the short term, but after that we will need to settle on a ‘cruising speed’ for the economy. Exactly what that speed is depends on many factors, not least how deep the COVID wounds are for different parts of the economy, and how much scarring will be there after they heal. This is the million-dollar question of course, and we will get a better picture of the outlook over the next few quarters.

Is Haldane right to sound the alarm on UK inflation?
A sunny start to June has brought some much-needed positivity to the UK. But with the economy still finding its feet and many looking forward to the recovery, delays and complications are not good for an economy that – in normal times – relies so heavily on its consumer services sector. As things stand, the UK economy has been doing well through the spring. According to the Office for National Statistics (ONS) growth data for April showed a rise of 2.3% which reversed all and more of the first quarter decline of 1.5%.

Andy Haldane, the outgoing chief economist to the Bank of England (BoE) – and its current chief provocateur – is worried about this strength. He was the only Monetary Policy Committee (MPC) member to vote for a slowing of asset purchases at its most recent meeting, and last week warned the BoE risked making a “bad mistake” by not acting faster to quell runaway inflation. Underlying Haldane’s warning is the resurgence of UK growth prospects on the back of the impressive vaccine rollout. Backing him up last week, Goldman Sachs has pushed up its 2021 UK GDP growth estimate to 8.1% (although some reports quoted 7.8%). Even including more pessimistic economists in the Bloomberg survey, consensus estimates have risen above 6% this year. Looking to 2022, the consensus outlook looks even more impressive. While the US and Eurozone are expected to fall to around a 4% rate next year, the UK is predicted to expand by 5.5% – a growth figure matched only by China among the world’s leading economies.

No one denies that this resurgence will come with an increase in inflation, least of all the BoE. The difference is that MPC members expect above-target inflation to be transitory, petering out as the economy finds its own feet. According to Haldane, the glut of household savings built up this year will be unleashed while the world still struggles with multiple supply issues. The resulting spike in consumer prices could be carried forward if increasing wage demands from employees lead to accommodating rises in real wages – with the potential to create a cycle of rising inflation expectations that affect the medium and long-term.

Perhaps supporting his view, the ongoing rally in UK house prices – a leading indicator of inflation over the medium-term – shows no sign of letting up. For the housing market, we suspect the link between house prices and inflation will not be obvious in the coming months. One of the key drivers of house price growth for the past year has been the suspension of Stamp Duty, which is sure to end sooner rather than later. Besides which, one of the key reasons the housing market has been so well-supported is that pandemic savings have been funnelled into it. This means we are unlikely to have both a rally in housing and a wave of spending in the next year – the central assumptions of Haldane’s runaway inflation scenario. The sun may be shining for now, and Haldane could well have a point about sunburn, but the BoE has a characteristically ‘British view’ of the weather. It will therefore be difficult for it to do anything other than choose to keep monetary policy loose for the foreseeable future.

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