My column for Netwealth: "Market Themes: Rebound, Recovery and Inflation"
Updated: Mar 25, 2021
This was published on Netwealth's Our Views on 19th March, 2021
Rebound, reflation and inflation are three of the key issues impacting the immediate outlook for financial markets.
Rebound will be evident as we move from the vaccine gap phase of the last year, to the roll-out of vaccinations. This will allow economies to be unlocked and consumer and business confidence to improve, unleashing pent-up demand and boosting investment plans. The UK, along with the US, looks set to be at the forefront of this rebound among western economies. As I have previously pointed out, UK economic growth is likely to be particularly strong over the remainder of this year and into next. The latest statements from the Bank of England reflect a more positive tone about economic prospects and a move in thinking towards this view. Yet, the Bank is still continuing with its previously announced quantitative easing and will do so until that is complete, probably this autumn, and it will keep policy rates unchanged for some time, at 0.1%. The challenge of an abnormal business cycle Reflation reflects the fact that the pandemic witnessed a huge unleashing of policy stimulus, in the UK and across the globe. Part of the challenge is that this has not been a normal business cycle, and thus the unlocking of economies should, as mentioned above, allow growth to rebound. Support to those areas and sectors that need it, not stimulus, should be the focus for policy. This year, the reflationary policies, which helped mitigate the downside impact from the virus last year, will still be feeding through, helping recovery. In view of this, attention across financial markets has switched to whether reflationary policies, which have allowed equity markets and sentiment towards corporates to improve, will lead to inflationary pressures. This has already pushed bond yields higher. In fact, this is just one of a number of uncertainties and risks that cloud the outlook. Even though UK growth looks set to be strong, there is uncertainty. We still do not know what the economic legacy of this pandemic on consumer and business behaviour will be. Could people be more cautious than we expect, and retain a very high ratio of precautionary savings? For instance, political uncertainty at the end of 2019 had already led to an increase in the savings ratio, from 6.3% in the third quarter (July to September) to 9.5% by the first three months of 2020. Then the pandemic hit and the savings ratio rose to 27.4% in the second quarter of last year and while it dipped to 16.9% in the third quarter, the accumulated excess savings was £125 billon last autumn and may be above £150 billion now. Where will the savings ratio settle? In the wake of the global financial crisis, the savings ratio rose, in 2009-10 to around 11%. While nationwide, savings have risen and corporate balance sheets appear healthy, not everyone is so fortunate. The unemployment rate is higher, and the debt overhang for many small firms is considerable. Emerging from the health crisis will be the trigger Then there is the health dynamic. Emerging from the health crisis will be the trigger for the UK rebound, but talk of a third wave of the virus on the Continent, including fresh lockdowns, highlights the continued global health risks and could delay recovery there. This may dampen, slightly, UK export growth but this impact should be offset by the overall rebound in the world economy. This global rebound will be led by China’s strong growth, where the recently announced official forecast of 6% for this year may be too cautious, and the US, where President Biden’s huge $1.9 trillion stimulus package is about to feed through. This leads onto the second key theme: reflation. That US stimulus is the culmination of a year of continued stimulus across the globe. Even the recent UK Budget, while containing significant future planned tax increases, will still provide a significant boost to the economy over the next year. The challenge is that while support to targeted vulnerable sectors and groups – whether in the UK, US or other western economies – is sensible and justified, it is that the scale of the stimulus has been significant. In addition to such fiscal easing, central banks continue to ease monetary policy. Some inflation concerns, but no panic In turn, this has led the markets to worry about higher inflation. Such concern is understandable. It would not be a surprise if there was some pick-up in inflation, as demand recovers and if supply takes time to respond post the pandemic. Commodity prices are firmer recently, reflecting this. In the US there is also additional concern. There, quantitative easing (QE) has increased the size of the Federal Reserve’s (the Fed) balance sheet, but whereas QE in the wake of the global financial crisis did not boost broader monetary growth, this time it has. The annual rate of M2 monetary growth rose from 6.8% in February 2020 to 21.9% by May and has remained high, reaching 25.8% this January. There are a number of factors contributing to this but, alongside the expected rebound in the US economy it has fed inflation worries there, and indeed globally. Despite market worries, the US Federal Reserve is not panicking and is keeping policy loose. In their latest statement, this week, the Fed said: “The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.” One of the major issues for the markets, and for policymakers, is what type of environment will we face? It is certainly no longer deflationary, as was the fear a few years ago, but is it disinflationary – where growth will be modest and inflation relatively low – or inflationary, with considerably higher inflation than in the recent past? The Fed’s Powell has already talked of volatile inflation, yet they see this as consistent with their unchanged stance. That is understandable, given the uncertainty that exists. Policy makers do not want to tighten policy prematurely before growth has recovered. While inflation could be higher and volatile in coming years, beyond that it still looks like a disinflationary outlook. That prospect suggests policy tightening can be gradual and phased, and not imminent.