Global growth is still on track but the resultant inflation could last
- Saturday, October 30, 2021
Leading fund management groups remain confident of a robust recovery in the world economy but this outlook has tilted in a stagflation direction as growth momentum fades and price pressure rises. Global growth is still on track but the resultant inflation could last.
The immediate post pandemic growth phase is coming to an end with peak growth behind us as the world now contends with weak supply chains, labour shortages, energy and commodity price rises, the growth in infection rates of Delta Covid and a spike in inflation. Inevitable rising prices will have an impact upon demand with wholesale energy prices, petrol prices and food costs increasing.
The signals that the initial recovery growth phase is slowing comes from PMI data. This was first signalled with a recent weakness in copper prices which is consistent with a slowdown in industrial demand. The increasing spread of the more infectious Delta variant has also slowed activity. Delta Covid is exacerbating the headwinds currently facing the world economy. Firms have run into bottlenecks in supply and then had to ease back on their own production for lack of components. This is typified by new car production that has stalled due to the lack of semiconductor chips. Order levels are high, but back logs and delivery times are delayed. The result has been price rises as buyers have then chased suppliers.
Production has been hit by a lack of labour which may be surprising given the level of vacancies and unemployment still above pre-pandemic levels. There are currently over 1 million unfilled vacancies in the UK and a 4.5% unemployment rate. The speed of re-opening combined with a lack of forthcoming applicants means vacancies have been left unfulfilled. The UK has for many years relied upon overseas labour and due to lockdown, many have left to go home and yet to return. Some worker shortages are down to childcare support, whilst as has been the case in the USA, many are better off on enhanced unemployment benefits. The recent uplift in unemployment payments have now come to an end so should encourage a higher labour participation rate.
The rate of labour participation in developed markets has been slower than business needed. In particular sectors people have simply not returned in the numbers desired. This has caused additional shortages in production chains. Against this background of increasingly tighter labour markets, wages are inevitable going to rise.
The US Federal Reserve is keeping a close eye on US labour participation ratios. This is the percentage of over 16’s that are working or looking for work. In the US there is still slack in the labour market with unemployment standing at 4.8%. There are three million people still unemployed as compared to pre-pandemic levels of February 2020. Unemployment is however falling and we would expect these shortages to ease through improved participation rates but supply bottlenecks expected to remain even into 2022.
With inflation pressure comes the need for action to control it. The Fed is moving towards tightening policy for the first time since the financial crisis of 2008. The Fed has signalled it intention to start reducing the level of quantitative easing (QE) bond purchases. It is expected this tapering will start in December at a pace of something like US$10bn per month reduction and therefore take 12 months to end the QE programme. Somewhere near the end of the QE programme, perhaps in early 2023, it is expected that the Fed will make its first interest rate rise.
While it may be over a year before the Fed is contemplating a rate rise, the Bank of England (BoE) have already signalled that they may start modest rate rises before Christmas. The decision over an interest rate rise will seek to dampen inflationary pressures but will have consequences for borrowers. Markets have priced in a December rise to 0.25% and expect the BoE to continue to rate rise through 2022 ending the year at a base rate of 1%. The BoE has certainly changed its view and policy over rate rises.
The ECB may be the last to rise rates as Eurozone inflation is not universally as high as the US and UK. The overall Eurozone rate of inflation is 3.4% but in Germany it is 4.1% while in France it is 2.2% and Italy 2.1%.
The ECB have continued to purchase European government bonds which has helped weaken the Euro. The extent to that the ECB will continue with QE will be made at the end of the year. The good progress that Eurozone governments have made in vaccination rates and the reduction in restrictions as well as the pent-up consumer demand has improved analysts’ expectations for GDP growth to 5.1%.
The UK has been hit by rising Covid infection rates with new cases a day recently hitting 45,000. This added to energy price and fuel increases as well as supply shortages and food inflation would suggest a disappointing outlook. However, the outlook for the UK is improving. The Office for Budget Responsibility (OBR) has lifted its prediction for economic growth in 2021 to 6.5%, up from its previous forecast of 4%. It has also reduced its estimate of the long-term “scarring” effect of Covid-19 on the economy from 3% to 2%. The OBR is now expecting the economy to return to pre-pandemic levels six months earlier than it had forecast previously.
UK CPI inflation was down at 3.1% in September but it is expected to hit 5% over the winter months before falling back as supply issues are resolved. The BoE are confident in the UK recovery but will monitor the employment market as the demand for workers has been stronger than expected at a time when the number of younger and older workers having left the labour market has grown. They will need to be encouraged back. The labour market is a key indicator of inflation as raw material prices are cyclical. If wage inflation starts to be embedded and in line with the rising cost of goods, inflation will be more persistent.
Any counter inflation interest rate rises could reverse these hard-earned growth forecasts. This is why the Fed is holding back interest rate rises until the US economy can take them more easily. The UK housing market has seen significant growth on the back of lockdown lifestyle considerations and the stamp duty holiday that extended to June. Any increase in mortgage costs could have an impact on house prices.
The major fund management houses continue to expect above trend economic growth through to the end of 2022 and see an upside in equity earnings as economies around the world further re-open fully and pent-up demand both materialises and can be delivered on. However, the momentum of growth did fall back in September but the Q3 earnings season results has been very encouraging and led to a recovery in stock market values. Third-quarter earnings season began in earnest during the second full week of October, led by banking giants JPMorgan Chase, Citigroup and Wells Fargo. Analysts at US financial data group FactSet estimate an earnings growth rate of 30% for S&P 500 companies, which would mark the third highest (year-on-year) earnings growth rate reported by the index since 2010. The S&P 500 has hit an all-time high of 4574 in the last week of October.
While businesses are facing headwinds an economically supportive backdrop remains in place with high liquidity, strong household balance sheets and an expectation over government spending plans.
The bond markets are likely to offer negative real returns throughout 2022. The 10-year US Treasury bond yield is currently standing at 1.6% having been 1.2% in July. Some analysts are predicting yields rise to 2.2% over the months ahead meaning that bond holders will likely to see falls in prices and value to compensate for the improving yields. We have reviewed our bond holding to ensure that we have exposure only to short dated and inflation linked credit which are more stable in these conditions. We are also researching the use of target return bond funds to aid our fixed interest performance and volatility.
Japan was behind in its vaccination program at the end of June as compared to other developed nations but since then it has rapidly improved and now has a high vaccination rate, ranking the country among the top three in the Group of Seven (G7) nations and ahead of the UK. Of Japan’s population of 125 million, 70.1% had received two doses of a Covid-19 vaccine.
Japan’s previously endless lockdowns had hindered economic recovery but the vaccination rates have reduced hospitalisation and deaths and with it these restrictions have eased. Consumption will improve along with wage growth. Meanwhile improving global trade will support Japanese manufacturing as well as technology and industrial companies.
China’s economy has seen a decline in 2021. Year on year GDP growth was at 18.3% in Q1, 7.9% in Q2 and fell to 4.9% in Q3 which is slower than many analysts had predicted. The Chinese economy had enjoyed a rapid V shape recovery after the first 2020 lockdown and benefited from early recovery growth but this has led to the authorities in Beijing putting the brakes on an overheating economy.
There have been disruptions to supply chains so that global inventories have been reduced. However, the months ahead should be ones of re-stocking and should stimulate the manufacturing sector.
Beijing has also put pressure on regional governments to reduce their carbon emissions in line with the nations goal to be carbon neutral by 2060. Twenty provincial governments have implemented electricity rationing which caused black-outs for homes and factories. This rationing coincided with the country’s largest coal producing regions suffering from torrential flooding, leading to coal prices hitting new highs and the government abandoning the production caps.
Domestic coal production has needed to increase as China is no longer importing Australian coal. Regional power companies are expected to make a loss due to the power pricing policy imposed upon them by Beijing. This policy controlled how much they can charge the customer. Now that this production cap has been lifted then capacity can improve.
Power black-outs have however hit the cement, steel and smelting industries that use high levels of energy, resulting in factory gate prices rising.
These energy supply challenges have come at the same time as the property real estate sector was rocked by the heavily US$300bn indebted Evergrande Group not being able to pay its bond holders. Authorities in Beijing are seeking to manage a re-structure and protect home buyers. Evergrande is China’s second largest property developer but had borrowing levels which are far higher than any other peer. China does need companies that fail and to teach speculators that there is risk and not government bail outs. It is expected that the failure of Evergrande will be a lesson to the property sector but contagion is unlikely. The Chinese banking sector is well capitalised and can afford a major write down so the failure of Evergrande will not be a Lehman Brothers. However, it will impact the general property sector with some resistance over lending and as the wider property and property related sectors make up 25% of China’s GDP then it could impact on growth. Interestingly however, the wider Asian credit market has seen record credit issuance which is a positive signal about confidence. Analysts are now predicting a change of policy in China with targeted fiscal policy easing.
India has overcome its devastating second Delta Covid wave and while the vast numbers of people hospitalised or who tragical died was heart breaking to see, India has got through it. Inflation is the new challenge facing the Reserve Bank of India (RBI) as inflation hit 6% again driven by supply disruption and commodity price rises. The RBI left its benchmark interest rate at 4% during its October meeting, as widely expected, saying it was maintaining an accommodative monetary policy stance as long as necessary to support economic growth and to help mitigate the negative impact of Covid-19. Meanwhile, the RBI lowered its projection for retail inflation for the full year 2021/22 to 5.3% from 5.7 % amid the easing of food prices. The Bank maintained projected GDP growth at 9.5%. Like many other central banks, the RBI expect inflation to fall back to around 4.5% by the end of Q1 and therefor transitory in nature.
Russia has been blamed for taking advantage and exasperating the current gas shortages. Russia is an energy power in both oil and gas and can control the global price of natural gas. Not surprisingly the Russian MICEX stock market index is up 26% this year to end of October, while Russian GDP growth is forecast to hit 4.5% in 2021. However just like other countries, inflation is the issue challenging the Central Bank of Russia (CBR). Russian inflation is currently 7.4% and interest rates 7.5%.
A key risk to the world economy at this time is an energy crisis over this winter that drives up the price of gas, coal and oil which in turn impacts upon production when there is a supply side shortage problem at play now. Any stubbornness in inflation will have an impact upon consumer confidence and challenge government debt management.
Capitalist economies are good at sorting out shortages with the movement of capital and resources to areas of bottlenecks, but this could take longer than normal. As supply improves prices will fall and inflation decline.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.