Monday digest
Posted 15 August 2022
Overview: Investor FOMO returns
Investors are feeling FOMO: the “fear of missing out” once again. Last week brought a continuation of the trend since early July, with boosts to both bond and equity markets. Curiously, the good feeling among investors seems unaffected by the bad news all around. Inflation is roaring ahead and consumers are struggling to keep up, central banks are intent on crushing price pressures with aggressive monetary policy, and talk of a global recession abounds. The growth slowdown is already being felt by companies. This year’s second quarter earnings showed a downgrade in forward-looking estimates for the next 12 months. And yet, stock markets continue to rally.
Naturally, falling earnings and rising stock prices mean equity valuations – on a price-to-earnings ratio – have climbed higher. This is a reflection of increased risk appetite. Equally important has been the fall in real yields. At the start of August, inflation-adjusted yields on 10-year US Treasuries once again sank to almost zero, and they are still well below their mid-June peak. This is largely down to shifting impressions of US Federal Reserve (Fed) policy. But it also shows investors are confident in the stability of financial assets, and in the Fed’s ability to promote a healthy US economy.
The key question is whether the medium-term macroeconomic backdrop has improved enough to justify this view. Markets are certainly betting it has, but we are not yet convinced, and the fact that markets are so confident is itself a cause for concern. Perfect landings are incredibly hard to achieve, and there are still significant risks to the outlook. Oil prices have fallen back, but any further reduction will be hard to achieve in the short term. China might be weak currently, but is likely to improve towards the end of this year. That will increase global demand for crude oil, which could hit US households just as they are starting to gain confidence. That would force the Fed to continue on its tightening path, dampening hopes of a monetary reversal. Such a situation could cause serious problems in the next couple of months, particularly for businesses required to refinance during that period.
The problem is not that the Fed is unlikely to get things right, but that markets have priced in such a high probability of success that any deviation could be devastating. The summer lull has probably helped prop up market sentiment somewhat. With many traders on holiday, it is much easier for markets to convince themselves everything is rosy. This lull coincides with a two-month break in Fed meetings, with the next one scheduled for the end of September. When that does come around, we should expect the Fed to have a renewed zeal for taming prices, which could provide a wake-up call for markets. We have never agreed with the doomsayers, and we still do not think that a global recession is inevitable (though recessions in the UK and Europe are all but certain). At the same time, we are slightly uncomfortable with the level of optimism implied by current equity values. We should enjoy the sunshine while it lasts, but future market improvements will need to be based on more than just the summer breeze.
Fiscal firepower in UK’s inflation fight
The increasingly bitter race to replace Boris Johnson has seen a host of promises from candidates on taxes, energy bills and welfare payments. But rampant inflation will be the main problem facing whoever wins the Tory leadership election. The stakes are high, and so far, the debate has focused on whether tax cuts or government spending are the best means of supporting people. In a recent article, senior figures from the Institute for Fiscal Studies describe how frontrunner Liz Truss’ promised tax cuts are ultimately unsustainable without a reduction in public spending somewhere down the line. All Tory leadership candidates emphasised the need for strong growth and the supposed ‘fiscal headroom’ of £30 billion, but there are serious flaws in these points.
For starters, that £30 billion would be easily eaten up by either a fall in tax revenues or a modest rise in unemployment payments. Considering the UK is set for a lengthy recession, both of those are likely. More generally, promoting short-term growth right now is at odds with taming inflation. The two forces generally keep each other in check, but Britain is now bracing for a recession coupled with persistently high inflation. This essentially means supply is so constrained that even economic contraction – and hence falling demand – is not quite enough to get short-term prices under control.
Faced with these intense pressures, what can any government do? Again, the fundamental problem comes down to the lack of supply. Right now, we are seeing this in energy markets, but the issue is a general one for the UK and has a longer-term characteristic. As both Tory leadership candidates are keen to point out, low productivity has held Britain’s economy back for well over a decade. This is down to a lack of investment, as well as deep-rooted problems in the labour market. Britain’s sluggish labour participation rate has gained attention in this regard, but equally problematic is the shortage of skilled workers.
This is not a short-term issue, though the effects of it are very much being felt now. A simple solution would be to increase immigration, but that seems unlikely in the political environment. Over the longer-term, investment in better education is another solution, but that is at odds with the government’s (even Rishi Sunak’s) desire to cut taxes as soon as practical. Or alternatively, other areas would need cutbacks. One way or another, supply and demand will have to be brought into balance. If that does not mean investing in more supply (particularly of skilled workers) it will have to mean crushing demand. The more the government shies away from this, the more aggressive the Bank of England will have to get.