My update on the current economic environment - slides and a summary
The UK and the global economy are returning to normal after the pandemic, but the economic rebound is triggering a whole host of issues. We've seen a rise in inflation. We're seeing concerns about exit strategies by central banks, and, indeed, by governments from their high levels of debt, and worries have also now arisen about the sustainability of the rebound that we're currently experiencing.
Over the last half year there has been an evolution in terms of these key issues. Six months ago, markets were focusing on the rebound as vaccines were rolled out, economies rebounded from the depths they hit last year, helped by reflationary policies. Then the situation evolved into a worry about inflation. More recently, the focus in markets has been about a deceleration in economic growth.
Naturally, the rates of growth economies are seeing at the moment can not be sustained. But six months ago, the feeling was also that growth rates would start to return to some sort of normality after the initial post-pandemic rebound. Now there are worries about a slowdown – partly because rising costs and inflation are starting to squeeze incomes both here and globally - and because of concerns about those exit strategies that I referred to above.
Let's highlight this in terms of the growth picture. Earlier this week, the International Monetary Fund (IMF) started their annual meeting in Washington. While the IMF is not necessarily the best forecaster of the world economy, they are seen as a good barometer of where opinion is. Here is their latest projection: in slide A2.
Let's look at the left-hand side, the global economy. Last year, the global economy suffered a deep recession because of the pandemic. This year the global economy is witnessing a strong rebound, maybe more than some people thought was possible a year ago, but actually slightly weaker than forecasters thought might be possible about only six months ago. It shows how sentiment changes, but nonetheless, it's a strong recovery of 5.9%.
While growth is projected to lose some momentum, it’s still pretty strong next year at 4.9%. In 2023, the general expectation among forecasters is that growth rates will slow further but back to somewhere around pre-crisis trends.
Also, as one can see above, the IMF sees the recovery being strong in advanced economies – Western economies – but even stronger still on the right-hand side, across the emerging economies.
Interestingly, the IMF believes the UK economy will grow 6.8% this year. That's slightly weaker than its forecasts a few months ago of 7.1% growth, but even its 6.8% forecast would leave the UK as the fastest growing G7 economy this year. The economy is set to reach its pre pandemic level, as we thought it would, before the end of 2021.
Whether it's the UK economy or the global economy, we are witnessing a combination of rebound from the pandemic – helped by the vaccine rollout in Western economies – and we're starting to see the continued impact of reflationary policies. As we have seen recently in the financial markets, there are still concerns about the future pace of growth in China and one or two other countries, so one should not assume that it's a smooth path ahead. But the key message is that there is an economic recovery underway.
The second area to focus on is inflation.
At Netwealth we have been asking the question for some months about which inflationary pressure it is. Is this pick-up in inflation going to pass through quickly? Is it going to persist, or will it become permanent?
Central bankers, in general, throughout this year have said that the rise in inflation we're experiencing is temporary, due to one-off factors. They're saying it's not permanent.
I would agree with them. However, as we've highlighted before, and as we're actually now witnessing, we felt that there was a danger that the inflationary pressures being experienced could persist. Not just here in the UK, but in other Western economies as well and indeed that is the case.
What we're seeing is a combination of factors coming together. The pandemic has led to major distortions in supply chains. And that's the initial focus of where people look to when they try and get to the bottom of what's causing this pickup in inflation – transportation costs have risen.
But it's not just that, we're also seeing costs pick up across most economies in all sorts of areas. Here in the United Kingdom, for instance, we've seen wage pressures rise and unit labour costs increase as firms try to get back to normal. At the same time, in many sectors, there is the ability for companies to raise their profit margins, not only passing on higher costs, but actually building in a bit more margin as people start to spend.
There is a wide combination of factors, and on top of that, monetary policies have been loose, particularly here in the UK.
So inflationary pressures are persisting, what does that mean? It means that the UK rate of inflation won’t necessarily return to its target rate of 2% anytime soon, which we can explore further in the chart below.
The Consumer Price Index, which is the rate that the Bank of England has the target for, is now 3.2%. Unfortunately, the retail price index (RPI) is 4.8% at the moment, so that tends to compound the squeeze on people's disposable income as the RPI sets the rate at which rail fares and the interest on student loans rise.
While the CPI is now up to 3.2%, it looks set to go above 4.5% before the end of this year and is likely to hit 5%. It would be the consequence of a major policy mistake for it to reach 10% as some people fear. But we are seeing inflationary pressures build and we believe that inflation will remain above the target over the next year and possibly slightly longer.
The third area to look at is policy.
Looking at the policy environment, we currently have a very difficult situation globally. Public debt levels are at an all-time high. Policy rates are low, although rates have risen recently in one or two countries. Central banks’ balance sheets have become bloated and also, financial stability risks have become more of a focus, highlighted recently by the worries in China’s property market and the global focus on the property firm Evergrande.
So we’ve got fiscal concerns, monetary concerns, and additionally financial stability concerns – a whole host of areas to keep not just policymakers occupied, but to keep us all on our toes.
Let's focus on monetary policy, that's the key in the very near term.
Low policy rates (in the UK they are at 0.1%) mean that financial markets do not price properly for risk. In addition, because of quantitative easing (QE), central banks, including the Bank of England, continue to buy assets. The key asset they are buying is government debt. As a result, bond yields are not reflecting true demand and supply because the biggest buyer recently has been a non-commercial player, namely, the central bank.
This has raised questions as to what constitutes a risk-free asset, and it also raises the question: how should central banks tighten policy? Should they tighten by raising interest rates, or should they exit cheap money by tapering, by reversing their QE?
I have written in The Times
https://www.thetimes.co.uk/article/now-is-the-time-to-tighten-monetary-policy-and-keep-a-lid-on-inflation-w5nd8nn7x and other newspapers about my preference. I said a few months ago that the Bank of England should tighten immediately, gradually and predictably so as not to cause shocks. I felt they should exit via reversing QE to take liquidity out of the system and to leave policy rates where they were.
The markets previously thought that the Bank of England would hike rates in February. Now there is a possibility they could hike as early as November – from 0.1% to maybe 0.25%, or potentially to 0.5%.
One of the reasons they're having to do this is because they've been slow to act, but also somewhat because the markets have already done the tightening for them. Ten-year gilt yields have risen significantly in the UK, partly because the market, looking at what was happening not just on the growth front but on the inflation front, felt that the Bank of England needed to act and would have to act.
So to conclude: central banks have intervened significantly across the globe. The question is, how do they exit? Do they exit by tightening, by pushing interest rates up, or do they exit by tapering? In the US, they've hinted they will exit via tapering, therefore delaying their rate hikes for some time. But here in the UK, you should anticipate a policy rate hike relatively soon.