Monday Digest

Posted 13 September 2021

Overview: major economies ponder how to pay the bill

At the beginning of last week, we noted the increasing importance of fiscal policy, and sure enough, the UK Government almost immediately delivered its own big fiscal bang. National Insurance contributions are on the rise, along with a further tax charge on dividends to fund the NHS and social care over the next few years. Generally speaking, the move bucks the ‘smart austerity’ trend which emerged after the global financial crisis and Eurozone debt crisis, whereby balancing the books should go hand-in-hand with structural reforms. However, the UK government’s measures are predominantly based on financial shifts – tax more to spend where needed – while offering little intrinsic reform of the social care system. We discuss the potential economic consequences in more depth below.

European markets found some calm last week after a turbulent September so far for fixed income and equities. At last Thursday’s news conference following its monthly meeting, European Central Bank (ECB) President Christine Lagarde assured participants “the Lady isn’t tapering” and postponed the debate around withdrawing stimulus programmes to December. Meanwhile, in the US, Treasury Secretary Janet Yellen warned it could run out of cash in October, after it hits the debt ceiling. Raising the ceiling is yet another political battle between Republicans and Democrats, as Republicans do not agree with the Democrats’ plan to spend USD 3.5 trillion on social care. For now, US fixed income markets remain unruffled – most likely assuming a compromise can be found.

Connecting the dots, markets are still focused on the themes of elevated valuations, an air pocket in economic growth and the removal of monetary stimulus. Comments last week from Bank of England Governor Andrew Bailey have positioned the UK as a front-runner in this respect, with markets believing his comments are almost certainly preparing the ground for a rate hike next year. The long-run fiscal outlook and economic investment activity will be shaping the nature of long-run asset performance. It looks like the UK is adopting more of a conservative stance than Europe and the US, but we’ll wait for the UK’s Spending Review and Budget on 27 October for confirmation.

Why the commodities transition presents new challenges
The economic recovery has been good to commodity traders. After sinking to extreme lows in early 2020, oil prices have gone from strength to strength – buoyed by hopes of rebounding global economic activity and supply constraints. But the pandemic has accelerated the global shift toward renewable energy, with politicians and pundits lauding the ‘green recovery’. Technology, research and innovation are being directed toward this transition – to the benefit of those commodities needed for producing green tech. Changing regulation and a raft of green infrastructure projects are providing huge demand for raw materials – particularly battery minerals such as lithium (lithium-ion for electric vehicles).

We are used to oil demand being the main indicator of global economic activity, but that will not last forever. A great deal of attention has been paid to what the green shift might mean for prices of different commodities. Policymakers have also started worrying about ‘stranded’ assets (like those related to oil) which will steadily drop in value down to zero – posing a threat to the wider financial system. But less emphasis has been placed on what it means for global supply chains. This is a critical question, because a change in material inputs naturally means a change in who the main producers are.

The often-complex nature of modern commodity production only exacerbates the situation. A break in any one part of the chain could threaten the global economy altogether. That is without even mentioning the political dimension. Given the increasingly fraught relationship between the US and China, there remains a significant threat of sanctions or worse. Diversifying production is therefore vital for making the global economy – and the green transition – more stable. New and varied commodity sources will need to be tapped, and while such operations are underway, they take a long time.

The green revolution could spark huge changes across the global economy. More than just replacing old materials with newer ones, the very structure of global markets is likely to shift. All of this requires careful attention from policymakers to ensure as orderly a transition as possible. But even with oversight, teething issues are inevitable and will only become more prominent in the years to come.

UK tightens its belt (and holds its breath )
It has been hard to escape the story of the week. National Insurance contributions are on the rise, along with a further tax charge on dividends to fund the NHS and social care over the next few years. The government hopes to raise an extra £12 billion a year for the beleaguered NHS, while capping social care costs at £86,000 over an individual’s lifetime.

The government was quick to point out the extraordinary circumstances. The pandemic delivered the sharpest recession on record while simultaneously putting the NHS under immense strain. The need for more resources and the worsening of the country’s financial health should be no surprise. But that will give little comfort to those affected by the tax hike. For investors, it means a decrease in dividend income after a year and a half of depressed pay-outs. And for the public, it means a hit to wages just as the economy begins to recover.

The Treasury has presented the bill as budget-neutral, but we suspect the reality might be a little different. Higher tax rates will come into effect in April 2022, the same time the new funding starts flowing, while the cap on social care costs will not begin until late 2023. From a purely economic perspective, even if the spending benefits perfectly match the estimated tax revenues, disposable income will still take a hit in the short-term. And people may not immediately feel the benefits of a better-funded social system. Moreover, tax increases can have a potentially significant impact on business and consumer confidence. Despite a sharp upturn from the depths of last year, economic growth and sentiment is still fragile. If people expect lower income in the future, they will likely slow their current spending – causing a knock-on effect on economic activity.

At the height of the pandemic, there was a political consensus that fiscal expansion was necessary to stave off ruin. And, despite some concerns from debt-conscious backbenchers, this political will later extended to longer-term public investment to aid the recovery. Now, it seems the dial has turned back toward fiscal conservatism accompanied with little reform – even though the recovery is still nascent, and virus worries have not fully subsided. That is not supportive for growth, to say the least, especially when compared to the bigger fiscal packages in the US and (to a lesser extent) Europe.

Equally surprising are the latest mutterings from the Bank of England. Governor Andrew Bailey suggested last week that the minimal conditions for raising interest rates were met – and that its rate-setting committee were evenly split on a rate hike. This comes after the Bank appointed Huw Pill, a renowned monetarist, as its new chief economist, and suggests that a rise in interest rates could come as early as next year. If it did, it would mean a de facto tightening of both monetary and (felt) tighter fiscal policy sooner than many would have expected. From the current data – as well as lingering Brexit difficulties – it is hard to see how Britain’s economy justifies such a move. At the beginning of this year, we listed premature policy tightening as one of the main risks to global growth; the UK could be in for a double shot of it. We should not overreact to the threat this poses, but we cannot underplay it either.