Monday digest

Posted 11 October 2021

Overview: global economy hits an air pocket

October has carried on where September left off, with daily ups and downs for markets, and with a slight downwards trend. Overall, after a week when European gas prices briefly hit a new record high, there was also the impression that this Autumn’s energy crisis gained some equilibrium. On one hand, President Putin indicated gas deliveries could be increased in a ‘quid pro quo’ for speeding up getting the Nord Stream 2 gas pipeline operative. On the other, for keen observers it was obvious that OPEC expects oil supply to outstrip demand again as early as January 2022.

Some political tensions were also eased further in the US, with the willingness of Congressional politicians to avert another imminent government shutdown – by agreeing to raise the debt ceiling until December. This was greeted with relief, taken positively by the markets and perhaps interpreted as a sign for more conciliatory behaviours towards the end of the year. In Europe, German coalition negotiations progressed much faster than anticipated, with public opinion swinging decisively behind a so-called ‘traffic light’ coalition between the Social Democrats, The Free Liberals and the Greens. Even Italy is looking more optimistic about the future than usual, with prime minister Mario Draghi, winning increasing backing from the electorate for his strategy of structural reform, feathered by fiscal support, and facing little challenge from the rest of the European Union (EU) over his plans for increasing Italy’s deficit again. Bond yields continued to support this narrative of future growth, with a continued gradual rise of yields in the longer maturity brackets.

That said, the short-term outlook feels increasingly uninspiring. Last Friday’s much-awaited US employment numbers failed to meet expectations (adding just 194,000 new jobs), even though the unemployment rate fell from 5.2% to 4.8%. Equity markets rose following the announcement, seemingly willing to ‘see the glass half-full’ in terms of not putting any more upward pressure on wages, which would in turn keep the US Federal Reserve (Fed) from tightening monetary conditions, as markets have been fearing since the beginning of September.
The second half of 2021 is not quite living up to expectations built up in the first half. Looking ahead, the persistence of the Delta variant, elevated inflation, supply chain blockages and spiralling raw material prices could increasingly dampening the previously upbeat sentiment. With the political standoff in the US over its debt ceiling, possible contagion from the collapse of Evergrande and imminent tapering from the Fed, we will be watching markets very carefully in the last quarter.

Trust in UK plc appears to be in short supply
Panic at petrol pumps and pig populations culled – it has been another painful week for Britons, with s supply shortages compounded by panic buying. Economists have speculated that this bandwagon effect might itself be a consequence of people’s perception of the crisis, and confidence in the government’s ability to manage it (or rather lack thereof). In any case, this perfect storm leaves the nation with more acute supply crunches than elsewhere, and sharp demand spikes to match them.
That is, naturally, a strong recipe for inflation, as evidenced in the recent data, with the consumer price index (CPI) inflation jumping to 3.2% in August. This was a 1.2 percentage point increase on the month before – the largest uptick since the Bank of England (BoE) gained its independence 23 years ago. Last month, BoE officials said they expect inflation to rise to 4% by the end of the year. All of this comes before the latest supply problems sweeping the country, which will only turn the heat up more.

Prime Minister Boris Johnson has been quick to accentuate the positives, suggesting Britain is experiencing teething issues on the way towards a more productive economy. He also declared wages are rising fast, particularly in previously low-paid areas. Indeed, the Office for National Statistics reported a significant annual wage jump in the second quarter of this year. Meanwhile, the BoE estimates current wage growth in the private sector at around 4%, well above pre-pandemic levels. In short-staffed industries the increases are even larger, with hourly wages for some goods vehicle drivers increasing as much as 15% this year. However, the spin can only go so far, and Johnson’s rhetoric doesn’t match the real-world experiences of the population, particularly when household costs are rising across the board, including higher taxes. For those who have seen their pay stagnate – or rise by less than inflation – that translates into a decrease in real disposable income. In areas with shortages, businesses are unlikely to keep increasing wages if it eats into their profit margins. Instead, producers will have a strong incentive to invest in automation technologies – as we are already seeing in the hospitality sector. If that happens, it will weaken workers’ bargaining power in exactly those areas where wages are currently spiking.

For overall growth, though, automation and improvements in productivity are a good thing. It translates into lower costs for consumers and, after the low productivity growth of the last decade, that will be a welcome sign. In the best-case scenario, this could mean wage increases for the low-paid and productivity improvements for everyone else. In the worst-case, wage hikes would be a one off and everyone would be hit with higher costs. We expect the longer-term outcome to be somewhere in the middle. The data produced in the next few months will be vital for figuring out where Britain lands. However, should wage and price rises indeed turn out to have been one-offs, then the ‘washing through’ of the 2021 rises after a year could mean that the current talk of stagflation may quickly become replaced in 2022 by lack of growth and disinflation.

Italy may have the leader to achieve its growth ambitions
After several decades of hopes rising and fading, the sleeping beauty of Italy could be ready to wake. To stimulate growth, Prime Minister Mario Draghi has adopted a twin approach: push for difficult structural reforms, while also administering a fiscal boost. This is different from the past, when Italy was careful to preserve its fiscal surplus (excluding interest rate payments for its past debt) to keep financial markets’ trust and to keep the peace with Brussels. The planned fiscal boost comes from two sources: using the European Union (EU) pandemic recovery fund, while also running a fiscal deficit. The former is smart use of money, the latter is challenging the EU status quo. Brussels has started a consultation of the Stability and Growth Pact (SGP), and Draghi’s fiscal plans have already made clear where he stands: soften the fiscal straight jacket. Draghi has already also earned a reputation in Italy as the person ‘nobody can say no to’ – let’s see how other EU nations respond.

The domestic tide seems to be turning, too. A series of important local elections took place across Italy in the last few weeks, and the results were encouraging for Draghi, with setbacks for Italy’s right-wing alliance. Nevertheless, the conservative alliance, headed by League leader and former Deputy Prime Minister Matteo Salvini, is still ahead in national polls. So far, there is no sign of popular revolt against the Prime Minister. That will be important in the months ahead. Draghi is going full steam ahead with a €3 billion pledge to help poorer households through the energy crisis this winter. In the face of energy price rises as high as 30-40%, Draghi has promised no short-term tax rises. Even more significant are his longer-term plans for tax reform. Draghi plans to revamp how Italian businesses and individual incomes are taxed by changing the calculation rules. These are all part of a modernising agenda. Crucially, his tax plans are needed for Italy to be eligible for around €200 billion in EU recovery funds.

Draghi’s reputation, especially outside of Italy, is arguably his greatest weapon. Politicians in both Rome and Brussels have a hard time saying no to the person who “saved the Euro”, allowing him to push for reform at home while simultaneously getting leeway in Europe. If Italian voters back him too, he will have a good chance of addressing Italy’s longstanding problems. The danger, however, is that Italy’s reform hopes are pinned on Draghi alone, especially if Draghi heeds calls to replace Italy’s President Sergio Mattarella, due to retire next year. His departure would create a significant leadership vacuum, and his successor would have large shoes to fill. For now, markets are pleased with Italy’s progress. But we should be wary of putting the country’s eggs in one man’s basket.