My latest thoughts on the investment climate
12th April, by Gerard Lyons
The big picture has not changed fundamentally over the last month. Latest developments and new information either reinforce previous views of slowing growth, rising inflation and tighter monetary policies in most countries, or – in a few instances – strengthen the alternative scenarios. In the latter camp might fall, for instance, latest comments from the Fed or the impact of the zero-Covid policy in China.
- At the start of the year the consensus view, which with we conferred in terms of growth, was that growth would lose momentum this year, as the post-pandemic rebound lost momentum, and previous policy easing either fed through or was superseded by monetary policy tightening this year.
- And by next year, official and market forecasts were that growth would return to pre-pandemic rates, of modest growth.
- Inflationary pressures were expected to rise. Here our thinking was probably more pessimistic than the market, in terms of its persistence, certainly in the case of the UK at least. But we still felt inflation would ease by next year and following, although perhaps settling at a higher rate than pre-pandemic.
- The variations in thinking were over how high inflation might peak and how long it may remain elevated. The general view was that inflation would subside by next year and then remain low.
- The war has exacerbated these issues, and in particular the likelihood of even higher inflation near-term has exacerbated concerns about growth slowing, as we move through this year.
The main issues over the last month have proved to be continuations of pre-existing themes:
1. Is the market right to assume a soft-landing?
- Is the danger that monetary policy has to tighten more to curb inflation, and that if it does, then growth will suffer more. It links to our previous discussion about r* - neutral interest rates. For even with the amount of tightening that the markets are currently factoring in, real interest rates (actual rates minus inflation) will be negative.
- Yet, market inflation expectations are such that the supply-side shocks that triggered inflation are not expected to persist, and monetary policy is not seen as leading to permanently higher inflation.
- Markets fear a hard landing, more than permanently higher inflation.
2. Elevated inflation risks:
Factors (a) to (d) listed here have fed elevated inflation risks.
- (a) The inflation numbers themselves. One of the biggest risks, as we have talked about, is that if inflation rises it unleashes greater inflationary pressures through cost-push inflation as firms raise prices to maintain margins, or through a potential wage-price spiral. There may be some evidence of both.
- (b) Food prices. Of all the issues linked to the war, perhaps it is the impact on food prices that is most significant.
o In March the UN’s measure of food price inflation rose by an annual rate of 33.6%.
o Last year food prices soared (up 28.1%) and this year they have surged.
o A key driver has been higher energy prices – in turn fertiliser and other costs have risen – and now the War with wheat and cereal prices soaring.
o Now, we have seen big moves in food prices before (up 25.5% in 2008 because of higher oil prices and then down 22% in 2009 because of recession). They also fell 19% in 2015 and then didn’t move much until 2020.
o But this time, the impact is at a time of wider inflation pressures. Also, most of the key components – meat, diary, cereals, vegetable oils and sugar – are seeing correlation and higher prices.
o (Note: this may also raise the attraction of food as an investment opportunity in its own-right.
- Food security is an issue linked to the war. Coincidentally, in December the UK Government produced a Food Security Report, highlighting how the UK imports almost half its food. Their concern that prompted that report is probably seen in other countries, too.
- The UN has for some time now highlighted food insecurity – because of population growth and rising food demand, higher food prices, and other issues.
- Also, environmentalists have highlighted soil degradation and water shortages as other issues impacting future food prices. China, Russia and Canada, are often cited as countries that may benefit from longer and warmer growing periods for some types of food but then China has acute water challenges. It is a complex area.)
- (c) Erratic but still elevated oil prices.
- (d) China’s zero-covid policy and in particular the three-week lockdown in Shanghai, a major port, will exacerbate supply-chain disruptions.
3. Tighter monetary policy
- (a) The direction of monetary policy has been clear (rates up and tighter policy with the exception of China and possibly Turkey). But the issue has been about the scale and speed of tightening. This will influence where r* is and also the shape of the curve.
- (b) Do the elevated inflation risks highlighted above point to monetary policy being tighter than previously expected and/or more than the market expects?
- (c) The Fed’s comments have been more hawkish. This has led to them being seen as ahead of the curve.
- (d) The Bank of England has now hiked for three successive meetings; the vote at the last meeting was 8-1, with one for no-change.
4. Growth worries
- (a) A global slowdown was expected. Recession seen as possible. Now, it may be that recession risks are higher. If so, are these risks higher in certain countries, or globally?
- (b) China’s zero covid policy clearly makes their 5.5% growth target for 2022 much harder to achieve. But they do have plenty of room for policy manoeuvre.
- (c) Growth will suffer from the cost-of-living (COL) crisis directly, and from subsequent policy tightening. The cost-of-living crisis is global in impact, but is western Europe and the UK more exposed?
o In most countries two components to the COL crisis, but in the UK there are three:
- Inflation outstripping wage growth
- Higher energy prices
- Higher taxes through a tighter fiscal stance (UK)
5. Currency issues
- As expected, the dollar continues to be firm
- Also, as I have previously highlighted, the yen is particularly weak, as yield differentials are key to the yen/dollar rate, and while the Fed is hiking the BOJ is committed to its yield curve control policy, keeping ten year yields low
- I am wary of sterling as economy could suffer from policy being too tight. Currency weakness would exacerbate inflation worries.
- Could the euro, like sterling, be vulnerable.
So five areas, highlighted above, to focus on.