Higher US inflation is one of three areas for market focus over the coming months
The immediate outlook for financial markets looks very constructive. Although we are still in a global health crisis, the vaccination programmes point to a strong economic rebound in the US and UK, following in the footsteps of the recovery that is well underway in China.
The last few days have confirmed a healthy corporate earnings season in the US and evidence of the strong recovery already underway there.
In addition to keeping a close eye on health developments, let me highlight three areas that could be of particular economic importance for financial markets over the coming months: further optimism about the pace of growth in the UK; rising inflation in the US; and an increased focus on exit strategies from cheap money.
First, is that the consensus is now moving towards the view we have held for some time: that there will be a very strong post-pandemic rebound in growth in the UK.
In one of our previous columns, two months ago, we pointed out the economy could grow by the equivalent of six years in ten months. At that time, we thought growth could be 7.8% this year. Even though that view is still more positive than the consensus, it may prove too cautious, given the scale of pent-up demand and the changing sentiment towards the UK as previous uncertainty linked to Brexit is replaced by the certainty of what lies ahead.
Challenges remain: as some sectors, like the arts and tourism, among others, take time to return to normal. Also, unemployment is yet to peak, although the recovery in payrolls suggests the picture will not be as poor as once feared. And, the scale of government loans, around £73 billion, suggests there will be an overhang of debt that may impact some small firms as we emerge from the crisis. Thus, while we will remain upbeat, it is important to neither be complacent nor surprised by what may unfold.
A second area to focus on is US inflation. Already this year, inflation expectations have risen. The next few months could trigger a re-escalation of these fears. If one looks at the month-on-month US inflation figures, there was a sharp rise in the latest data, for March, of 0.6%. This followed increases in previous months of 0.4% (in February), 0.3% (in January) and 0.2% (in both December and November). The combination of a recovery in demand now, in the US, plus possible supply-bottlenecks as things take time to return to normal, could trigger some temporary inflation pressures.
A year ago, though, as the pandemic hit, there was deflation with prices falling. This was evident from the month-on-month US inflation figures a year ago, with prices falling 0.3% in March 2020, 0.7% in April and 0.1% in May. Thus, it would not be a surprise if there was a significant rise in year-on-year rates of inflation in the US.
This is already happening. Annual inflation rose from 1.7% in February to 2.6% in March. With food and energy prices rising, the year-on-year rate could possibly increase to 3.9% in April and 4.5% in May. If so, this would give further energy to the inflation debate.
Core US inflation excludes food and energy and is lower, but still rising, up from an annual rate of 1.3% in February to 1.6% in March. Meanwhile, a broader measure of inflation, the Personal Consumption Expenditure (PCE) deflator followed by the US Federal Reserve Board is currently at an annual rate of 1.4% in February but looks set to rise above 2% in coming months.
The Fed’s message – that they reiterated over the last few days at their April policy meeting – is that policy will remain on hold, as they view a rise in inflation now as “transitory”. Their policy is to tolerate an increase in inflation to above their 2% target, and instead focus on an average 2% inflation target. Therefore, they will accept a rise in inflation. They also have a clear focus on a further improvement in the US jobs data.
The challenge, though, for the Fed may be to reassure the market that any rise in inflation over the coming months is temporary. We think they are right and, indeed, in our view, in the US as in the UK, inflation will be higher and more volatile in coming months. The UK’s annual rate is 0.4%.
The global recovery, led by China, will likely generate much firmer commodity prices, although for a combination of reasons, a firming of oil prices may occur later this year and into next. This will ensure that inflation worries persist and even though we think this pick-up will be temporary, it could push bond yields higher in coming months, particularly if it triggers doubt about the policy environment.
That leads us onto the third area, a focus on the policy debate, particularly in the US, where another large fiscal boost is being debated, in addition to the recent $1.9 trillion stimulus, and the already accommodative monetary stance. If anything, there may be renewed focus on when the Fed will taper its asset purchases, currently standing at $120 billion per month.
Globally, policy had to be eased last year and this, due to the pandemic. But just as policy had to be eased so it will need to be tightened. However, to exit from low interest rates, bloated central bank balance sheets, expansionary government spending and high budget deficits may prove far harder than to ease policy. This is a challenge not only for policymakers and for politicians, but also for the economic and financial market outlook, too.
In recent years preceding the pandemic, one of the growing concerns among economists was the worry that the policy cupboard might be almost bare were there to be another economic shock. It was part of the background to the US Federal Reserve raising interest rates at the end of 2016 (from their previous low of 0.25% to a cyclical peak of 2.5% by the end of 2018), which was where they stayed until being cut in July 2019.
At the end of 2018, the message from the Fed was that it still had to hike further to normalise rates, probably to around 3%, but then it had to reverse tack as the economic outlook deteriorated in the face of a trade war. Rates subsequently plunged during this pandemic. Fiscal policy has also been relaxed significantly, in the US and globally.
Exit strategies will vary across regions and countries. China, for instance, has already slightly tightened credit conditions. In contrast, in western economies, central banks, like governments, will be keen to avoid any premature tightening until they are sure that the health crisis is over and that the imminent economic rebounds are sustained.
Thus, while we expect policy to remain accommodative and on hold in the US and UK, the combination of recovery plus an uptick in inflation over the summer may trigger renewed focus on when exit strategies will have to commence.