Mr Powell’s skills will be tested in navigating the twin gods of growth and inflation.
- Friday, September 3, 2021
The backdrop to the Federal Reserve’s Open Markets Committee (FOMC) meeting in August was rising US inflation of 5.4% in July, unemployment standing at 5.4%, interest rates at 0.25% and 10 million job vacancies. Not surprisingly, Jerome Powell signalled as expected, the start of the scaling back of the Feds US$120bn monthly bond purchases. The threat of inflation and the recovery in labour markets meant that quantitative easing (QE) will now start to be tapered. This stance is likely to be followed in the UK, Eurozone and Japan as the level of easy government money is withdrawn gradually from markets.
Jerome Powell reassured markets with his careful comments about ensuring inflation runs at levels consistent with the Feds goals. Mr Powell also reassured markets that the Fed would take longer to raise US interest rates from their current record lows as ‘this would take different and substantially more stringent tests’ as compared to the reduction in QE purchasing rates.
The Fed is very aware that the highly contagious Delta variant has upset market expectations that a progressive roll out of the various vaccines would be sufficient to restore the global economy to pre-pandemic growth rates. Global supply chains, and labour shortages in certain sectors are impacting on both growth and inflation. The Fed is very aware that a move on rates too soon will have damaging consequences.
This policy announcement from the Fed was always going to be a major event and one watched closely. We are entering into a new period of reducing easy money supply after a period of rapid corporate earnings growth as economic activity bounced back. Whilst economic growth is expected to continue it will not do so at recent rates of recovery. This should support equity markets as long as the Fed maintain a clear and supportive policy that can hold bond yields.
Markets seem to have accepted that central banks may be correct in their view that our current spike in inflation will work through. We have recently seen equity markets rise while bonds fell as a sign of normal market behaviour being re-established. This does not mean we will not witness volatility as any rise in bond yields, as we saw in February when US Treasuries spiked to 1.75% will impact rich equity values. US Treasuries now stand at 1.3% illustrating the reduced fear of longer-term inflation.
The Feds position is in line with market expectations and took the Feds announcements well. The US stock markets hit new all-time highs this week with the S&P 500 hitting 4524 and the Nasdaq reaching 15309.
US inflation led the developed world as headline CPI hit 5.4% in June and 5.4% again in July. However, core inflation did come in less than expected gaining only 0.3% month on month in July as compared to 0.9% in June. This was the smallest increase for 4 months and resulted in a 4.3% rise in July as compared to 4.5% in June.
There is evidence that price pressure has started to weaken in the re-opening sectors such as flight and transport costs but rents remain pressured. The level of available workers coming back to the market once the Federal unemployment grants end, should curtail wage pressure and inflation. Commentators are suggesting that US inflation is starting to fade but will be stubborn.
The Delta variant is still causing severe problems across the world and restrictions could continue for some time until vaccination rates are universally sufficient. Nothing in the data about the Delta variant is showing it to be more dangerous than others and therefore the vaccination programmes should be able to cope. However difficult these restrictions may be, they should be temporary and prices can be expected to normalise once manufacturing and supply logistics adjust and reinforce their procedures to match demand. This will take time to work through, during which there will be cost and price inflation. Timber prices are a good example of this as supply issues have eased in recent months causing prices to fall just as quickly as they rose earlier in the year. The Timber Futures Index hit US$1700 in May and fell back to US$491 in August where it started the year.
The Federal Reserves policy framework for inflation allows it to run above its 2% target for periods to balance periods of under shooting. The big spending White House is preparing for a US$3.5tn Budget Bill, and this is likely to have an inflationary impact once added to expected domestic consumption. If supply chain disruption continues longer than hoped, Mr Powell’s skills will be tested in navigating the twin gods of growth and inflation.
The cost of European living rose by 3% in August, which is the highest increase in European inflation for nearly 10 years. This rise is over the ECB inflation target of 2% and will be of some concern, particularly to Germany as they are by nature very sensitive to excessive inflation. Their own inflation rate was recorded at 3.5% and is expected to hit 5% by Christmas. The eurozone interest rates are still in negative territory at -0.5% and the ECB is purchasing €1.85bn worth of eurozone bond to stimulate the economy. The ECB, just like all other central banks are hoping that the spike in inflation will faulter as supply chains recover.
In the UK, retail prices rose by 0.4% in August due to higher commodity prices, shipping costs and shortages of micro chips for cars and electrical goods. It is expected that these shortages in supply and delivery will hit Christmas stock.
The UK’s rising inflation is likely to limit some of the options that Chancellor Rishi Sunak was wanting for his next budget. About a quarter of the UK’s £2.2tn national debt is index linked. Any increase in inflation will result in the treasury paying more out to gilt holders. UK inflation hit 3.9% at the end of Q2 and is expected to rise to 4.9% in Q4. Every extra 1% increase in inflation will cost the government £6.5bn.
UK companies are expressing increased confidence as looser covid restrictions are allowing more of the economy to recover. The Lloyds Business Barometer is indicating a record number of UK firms planning to employ more staff and raise wages, with construction, manufacturing and service sector showing the greatest optimism. Staff shortages, supply chains and increased costs are the biggest concerns.
The IMF has upgraded its outlook for the UK and is now anticipating a 7% growth in UK GDP this year. Britain is expected to have the joint fastest growing economy in the G7 nations alongside the USA.
The markets that have been in the past most sensitive to any withdrawal of US QE has been the emerging markets. Emerging market economies were hit hard in 2013 when the then Fed Chairman Ben Bernanke, unveiled a plan to remove stimulus sooner than may have been expected. Gita Gopinath, the chief economist at the International Monetary Fund made the point by warning the current Fed board not to scale back the Covid support too quickly. Her initial concerns were not realised as emerging markets responded well to the Fed policy position. Most emerging economies are less dependent upon US$ denominated debt and hold foreign currency reserves so their vulnerability to Fed tightening is not like it used to be.
Perhaps the most significant growth story is that of India, who’s economy has rebounded at a record rate in Q2 even as the devastating second wave of Covid hit the country. India saw a 20.1% quarter on quarter increase in GDP growth. The Indian government put this down to private investment and consumer spending at the same time as manufacturing and construction grew. The Modi government has prioritised investment in national infrastructure which is much needed in India, the privatisation of state-owned companies and tax incentives as the means to drive growth.
A market bubble that has a major influence is that of the Chinese property market. Home building and property make up 17% of Chinese GDP and along with associated activity like furniture and appliances then nearly a quarter of China’s growth comes from the property sector. China is already slowing its overheated economy with credit restrictions and this is impacting the property market. However, China cannot let this sector falter as any correction would be damaging. Premier Xi Jinping is however trying to control what has become the world largest financial bubble with US$5.1tn of mortgaged debt sitting against it.
The curbs on credit will reduce access to mortgages which in turn should dampen demand and prices. This may be seen as an assault on ‘Red Capitalism’ and China’s desire for a western lifestyle and culture but it is having an over bearing influence on the health of the Chinese economy. Chinese people are focusing on buying a home ahead of starting a family. Fertility rates have fallen 1.3% despite the end of the one child policy which has now been increased and encouraged to a three-child policy. Housing in Hong Kong, Shenzhen, Beijing and Shanghai are the top 4 cities in the world for the highest house price to average wages. In Shenzhen for example this reaches a ratio of property value to average earnings of 43.5 times.
With the Chinese housing market holding US$5.1tn of debt this will be a delicate balancing act to deflate the bubble and one the whole world will need to watch.
Our latest Edition 35 asset allocation is one we are for the times we are living in quite comfortable. We have reduced duration in our credit markets to protect against inflation and as this threat recedes, we can lengthen our gilts and bonds. We are overweight in the US and have meaningful holdings in Asia, UK and Europe but have reduced our exposure to China and emerging markets. We have benefited from our allocations in property, infrastructure, insurance, financials and technology. We are making progress in recovering the falls in March due to our short-lived exposure to the iShares Clean Energy Fund and longer dated gilts that caused our portfolio correction.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.