Three key drivers of markets
Central banks in western economies need to be tightening policy by scaling back their printing of money via quantitative easing (QE). This will be the conclusion that markets are likely to come to in coming weeks, with the focus on the US and the UK.
There are three key messages to highlight, echoing points made here in recent months, where we have been upbeat about UK growth and cautious about US inflation.
The big picture
First, let’s step back and look at the broad picture. This was a health crisis that, along with government lockdowns, hit economies hard. It was the combination of the pandemic and lockdowns that resulted in this being a very different type of economic shock to, say, the one that followed the global financial crisis of 2008. Hence, the recovery this time may be far quicker, although because some sectors were hard hit there will be lasting consequences through scarring.
The health news varies across the globe. The latest from India is terrible, while also in recent days, it is noteworthy that various forms of new measures to curb transmission have been taken in Singapore, Japan, Malaysia and the Philippines. In the latter, for instance it has involved the reimposition of lockdowns in Greater Manila which accounts for one-third of that economy.
The reason to draw attention to these is not because they drive global markets, but rather as they are a reminder of how the global health picture varies considerably, influenced heavily by rollouts of vaccines.
As countries emerge from the health crisis, unlocking occurs and economic rebounds are being seen. China led the way, but it is interesting to note there, that as the year is progressing, a prudent and flexible monetary policy is leading to tighter credit conditions. That will likely slow the pace of economic growth in China as the year progresses.
It is another important reminder that while economies will rebound as they are unlocked, the pace of growth will be influenced heavily by the policy environment, which has been strongly reflationary across many countries. This is an important issue for the US and UK, in particular.
“Rebound, reflation and inflation” was how we posed this, earlier this year. While policy stimulus was necessary as the pandemic hit, it is less so now, particularly on the monetary front, as economies start to rebound and recover. This challenge has been compounded by the scale of the fiscal stimulus announced this year in the US. Now, with UK growth rebounding and US inflation rising, this policy debate will likely be a central focus for markets in coming weeks.
8.2% UK growth expected in 2021
Second, we have revised up our forecast for UK growth from 7.8% for this year, to 8.2%. We have had a positive view of UK growth this year for some time. Our thinking remains the same as before, but now, in the wake of the first quarter GDP figures, we have tweaked our forecast higher.
When the third lockdown was announced the initial fear was that it would be as severe as the first, hitting the economy hard, but very quickly it became clear that the Government and businesses had heeded the earlier lessons and more parts of the economy remained open.
That then led us to expect a first quarter (Q1) contraction of between one to two per cent, while the consensus at that time was for a four to five per cent fall. As time has progressed, the consensus became less pessimistic about Q1 and more upbeat about the year in full. That made sense and has now been seen in the data for Q1.
The UK contracted 2.5% in January and 0.7% in February before growing 2.1% in March, with construction particularly strong. As a result, the economy at the end of March was 5.9% below its pre-crisis level of last February, and 1.1% below its level of last October, before the second lockdown. As a result, the economy contracted 1.5% in Q1, although in nominal terms the contraction was only 0.1%. That is because the GDP deflator, the widest measure of inflation, was up 1.4%.
Pre-crisis level before year-end
The successful vaccine rollout plus unlocking could now see the UK economy return to its pre-crisis level by the fourth quarter of this year. However, to reiterate a previous point, higher unemployment and the fact that £73 billion of government loans made to help firms last year will need to start being repaid, suggests that not all parts of the economy will be able to rebound so quickly.
The debt overhang for small firms remains a concern as they are often important in rehiring as an economy recovers. This means specific help may still need to be provided as the economy recovers. The fact that the fiscal position will start to improve as the economy recovers should allow the Chancellor scope for targeted measures, if necessary.
US inflation rises
The third key message to highlight is inflation. A few weeks ago, we warned about higher US inflation in coming months, expecting a rise in consumer price inflation (CPI) to 3.9% in April and 4.5% in May. Inflation fears certainly now occupy centre stage in the financial markets, following the release of April’s CPI that showed a rise in the annual rate to 4.2%, versus market expectations of an increase of 3.6%.
Stripping out food and energy prices, the “core rate” of CPI rose 0.9% on the month, versus the market’s expectation of a monthly rise of 0.3%. Since last year, the US Federal Reserve (the Fed) has indicated they will tolerate inflation being above their 2% target, instead focusing on an average inflation target of 2%. In recent months this has led the market to discount no change in policy rates for some time.
The Fed also has an employment as well as an inflation mandate, and recent news of a weaker than expected increase in US employment in April still leaves the numbers in work well below pre-crisis levels.
Transitory and tapering
All this suggests the Fed will keep rates low and unchanged. However, April’s sharp rise in inflation, and the possibility that this may be repeated in next month’s data for May, will raise inflation expectations in the financial markets and exert pressure on the Fed to taper, that is reduce, their monthly purchases of bonds through quantitative easing (QE).
There was a similar focus on the Bank of England’s QE policy ahead of their early May monetary policy meeting at which the Bank revised up their forecast for economic growth this year but decided (by a vote of 9-0) to keep policy rates at 0.1% and (by 8-1) to continue their QE programme of buying gilts.
Perhaps the two key words are transitory and tapering. In recent months, a key focus in markets has been on central bankers emphasising transitory, with a focus on whether any rise in inflation will be permanent or not. That will now likely be joined by a market focus on whether there should soon be tapering.
The US and UK are rebounding, helped by vaccinations and unlocking and by reflationary policies. As growth increases and inflation rises, the debate will turn to whether this increase in inflation is transitory or not, and to whether monetary policy needs to tighten, gradually.