Posted 17 January 2022
Overview: Markets blow hot and cold
London was a tale of two cities last week, with panic in Whitehall but calm in the City. The scandals kept coming for Boris Johnson, with several Tory MPs openly calling for his resignation and betting markets putting the Prime Minister at odds-on to resign this year. But capital markets took no notice. UK assets outperformed on the week, with both the FTSE 100 and sterling finishing higher. In fact, UK markets have been on a good run for over a month now. What markets are happy about is the latest COVID numbers, as well as the government’s response. The rapid transmission of Omicron – and particularly its ability to infect vaccinated people – was a big concern for markets in December. But with cases falling and high levels of immunity, Britain’s economy could do well this year and currency markets seem to agree. Downing Street’s unwillingness to impose heavier restrictions has meant economic activity has stayed reasonably strong – meaning the recovery can continue uninterrupted.
However, the last couple of days resulted in a slight reversal, as long-term bond yields tailed off toward the end of the week, while global equities struggled to find support. Much of this was down to disappointing economic data. US retail sales in December were well below expectations, as sales value declined 1.9% (seasonally adjusted) and an even worse 2.5% month-on-month after stripping out fuel and car purchases. When you also consider inflation is at its highest in decades, it will mean a fall in real disposable incomes and suppressed demand. For equities, that has seen investors swing from anticipating sustained global growth to factoring in markedly slower earnings growth as consumer demand subsides. The flipside of this is that the problem looks more US-based than global. US equities – particularly the mega-cap tech names – could fare less well than over the last two years. For now, UK and European equity performance backs this up – with this side of the Atlantic likely to exit the omicron slowdown earlier and experience another year of a marked activity upswing in the spring.
The ups and downs of last week’s stock markets was a fair reflection of the competing economic dynamics still at play. The threats from rising yields and inflation pressures on one side, and support from a sustained economic recovery on the other could well bring about an overdue market rotation and the chance to turn a page. A move away from the darlings of the pandemic and into the shunned cyclical recovery plays that will see demand increase when COVID no longer dominates our lives. It is still too early to say which way 2022 is going to tilt, but the latest market signal – together with the rapid reduction of infection numbers in London – means a more pleasing springtime is looking more probable.
“Transitory” – the 2021 word of the year in capital markets – was officially retired by US Federal Reserve (Fed) chair Jay Powell back in November, and officials have talked tough on fighting inflation ever since. Patrick Harper, president of the Fed’s Philadelphia branch, was the latest to let out a hawkish cry this week, when he gave his support for raising interest rates in March. Inflation levels are “very high, very bad”, according to Harper, who is even “open to more” than three rate hikes this year should US prices continue to jump. His concerns echo Powell’s, who used last week’s Senate confirmation hearing to warn of the “severe threat” price instability poses to the US economy. Data released the day after the hearing seemed to underline Powell’s concern: inflation as measured by the consumer prices index (CPI) reached 7% year-on-year in December, a step up from November’s 6.8% and the highest annual figure since 1982. An interest rate hike in March now looks all but certain.
It seems the T-word is not just retired, but dead and buried. However, this may prove hasty. While many economists were concerned about the Fed’s nonchalance around rising prices, at least some of the intense inflation pressures of last year could still be short-lived. The transitory inflation debate has always had two components: short-term price pressures arising from pandemic-related quirks, and the longer-term structural trends that will set the course for the global economy afterwards. Last year, the doves argued short-term issues would subside, while structural inflation pressures would not be enough to embed price rises. We now know supply chain problems have lasted longer, and bitten harder, than many expected, while worker shortages – from COVID or otherwise – have been widespread. Commodity prices rose consistently through 2021, feeding through into sustained price increases for consumers. Prolonged pressures have had a big impact on people’s expectations too, with businesses and consumers preparing for higher costs this year (particularly on energy).
Despite these perceptions, short-term inflation pressures finally appear to be easing. Input prices have already slowed down considerably, and at this stage in the cycle we are unlikely to see a repeat of last year’s commodity boom. Oil is a possible exception – with supply driven by geopolitical interests – but even here prices arguably have little room to climb (OPEC+ members and US shale producers have a strong incentive to increase supply as prices rise). This is not to say input costs will stop rising altogether, or let alone go the other way, but we appear to be past the peak. In the US, December’s annual CPI increase was the highest in decades – and was supported by rising prices across the board. The month-on-month increase was more muted at 0.5%, down from 0.8% in November. Energy prices – which have a lagged impact on other goods – fell 0.4% from the month before. None of this suggests inflation will fade or reverse, but it shows momentum is slowing. If supply problems continue to clear and demand growth subsides, we are sure to see less price action later this year.
The key factor to watch is the labour market. Labour participation rates have dropped markedly throughout the pandemic, many argue irreversibly, while governments and businesses have altered supply chains to become more regionally focused. Even before the pandemic, global labour supply was stalling as many regions became less open to immigration. With furlough and work-from-home orders over the last two years, additional pressure has come from many deciding to hold out for better jobs or retire altogether. This is likely to change should savings decline or wages improve, but we still do not know when – or by how much – this will happen. Immediate pressure is likely to subside throughout the year. If it does, inflation expectations will cool – as will the urgency around monetary tightening. Beyond that point, the post-pandemic labour market should be much clearer.
Why China’s COVID policies are making waves globally
The global growth cycle – which has stalled and spluttered through numerous COVID waves – might finally become sustainable this year. Investors seem to agree, as the aforementioned equity market shift shows. The major threat though, is China, which appears to still be pursuing a zero-COVID policy. With Omicron proving incredibly infectious, harsh lockdowns are continuing while economic activity is still suppressed. This is now threatening to disrupt supply chains even further.
The State Council cabinet met last week and acknowledged the slowdown, promising to increase the spending of money already raised last year, and to raise more debt (in local government bonds) to spend quickly. China’s banks are reluctant to purchase more of this debt, despite ‘strong’ encouragement from local authorities. Government policy certainly plays a big part in this reluctance. Last year, Beijing cracked down hard on large parts of its private sector last year, compressing profits to the point of making some industries legally unprofitable. Plus, after the collapse of Evergrande and other large companies, credit demand has slowed more than the authorities intended. Last year, banks thought they had financed well-supported local government ‘financing vehicles’, only to find they had been duped by corrupt officials, with credit officers then blamed for not doing their job. They are (understandably) anxious about doing so again.
The Chinese government will do what it can to stimulate more activity, but this may prove difficult while maintaining lockdown policies. Overall, it means China’s continued weakness is a concern for the global economy. Supply chain problems were extremely damaging last year, pushing up inflation to uncomfortable levels. We still expect many of these short-term problems to drop away, but if Chinese production slows dramatically, it will only add to supply side pressure, making it one of the biggest threats to the positive cyclical view.