Quarterly Investment Update - From great to merely good: is that good enough?
The recovery has come off the boil, but we think it will continue supporting the markets.
Data released since our last quarterly update confirms that global economic output rose above pre-pandemic levels in the spring of this year, a far faster rate of recovery than thought likely in the spring of 2020. Even in countries that endured the largest contractions, such as the UK, the pace of recovery has been greater than anticipated. It’s likely that the UK’s output will reach pre-pandemic levels by the end of the winter – a good nine months or so faster than we forecast this time last year.
"It’s likely that the UK’s output will reach pre-pandemic levels by the end of the winter – a good nine months or so faster than we forecast this time last year."
The global economy has now entered a more challenging phase of its recovery. Gauges of business and consumer confidence have fallen as the world faces ongoing, asynchronous waves of Delta, a steady slowdown in China, and both product and labour shortages. Using the UK as an example again, retail sales fell in August for the fourth month in a row. A pullback in consumer spending on goods is to be expected: most have spent more on goods over the past 18 months because our spending on services has been restricted. Yet growth in the rest of the economy barely offset the pullback shown in the latest data from July.
We don’t expect the UK’s experience in July to become the norm across the developed world, but the present situation makes for a wider degree of uncertainty around our central forecasts than usual. Investor expectations for profit growth are high, as are equity valuations. If leading economic indicators continue to retrench further, then profit expectations may fall taking stock prices with them.
On the other hand, our analysis suggests the risk of a recession over the next six months is low. We believe the risk of a monetary policy mistake, which often triggers a recession, is very low (we talk more about monetary policy below). Business leaders still express cautious optimism about the need to invest, which should help perpetuate the nascent capital-expenditure recovery. Encouragingly, as we write, some of the regional manufacturing surveys (ones conducted by the New York or Philadelphia Federal Reserve Banks, for example) have improved again. These often predict improvements at the national level. The robust economic recovery in Europe appears to have lost some momentum, though it remains strong. September flash PMI surveys – which track businesses’ outputs, upcoming orders, costs, hiring intentions and mood – fell back from their peaks in both manufacturing and services, but remained at still-elevated levels of 58.7 and 56.3 respectively (above 50 indicates expansion).
Some of our more commercially minded clients often ask us, ‘where are we in the business cycle?’ Many economic indicators are consistent with the mid-cycle expansion phase. Economic growth is past the peak, but the level of growth remains strong. Historically, this phase tends to come with some volatility, but only a temporary pause in rising markets. At this stage, you tend to beat equity markets by seeking out companies with strong earnings momentum. Strong balance sheets and surplus cash flow over cash costs are also markers of companies that can glide over any mid-cycle bumps.
You may have read some commentators fretting about ‘peak growth’. We think they miss the point on this concept. Quarter-on-quarter growth has, of course, peaked as the big post-lockdown release is now behind us. The key question should be whether economies’ growth rates will decelerate rapidly to their mostly meagre post-financial crisis trends or whether they can sustain a faster rate of growth for another year or two after the reopening pulse is over. We believe it’s the latter. So, will going from great to good still be good enough for markets?
While most economic indicators are consistent with the mid-cycle phase, labour market signals suggest we are still in the early-cycle phase. This is good news for investors: relatively robust business activity yet with enough slack in the labour market to temper wage pressures on profit margins. And, because the US Federal Reserve (Fed) is tasked with stabilising employment not growth, it can keep American monetary policy looser for longer, which is important for the global economy, not just the US’s.
Bottlenecks and inflation
The risk of inflation continues to play on many investors’ minds. As we set out in our previous quarterly update, we believe today’s uncomfortably high rates of inflation will prove transitory. But transitory is an imprecise term, and we think that global inflation will take a little longer to fade back to a little higher level than that currently predicted by the bond market.
For today’s very high rates of inflation to become permanent or spiral higher, wage inflation must accelerate persistently, and inflation expectations must untether from the 2% rate embedded by independent central banks over the last 30 years. There are limited signs of this. Fed Governor Lael Brainard, possibly the next Fed Chair, lamented in a recent speech that despite the Fed’s new flexible approach, and despite the recent run-up in CPI inflation, long-term inflation expectations are still below the average rate of the last decade. The US 10-year ‘breakeven rate’ – the average inflation rate required over the life of an inflation-linked Treasury bond to make it more profitable than its conventional counterpart – is still below where it traded between 2011 and 2013. Back then, the global economy was dealing with the deflationary aftermath of a balance-sheet recession (the global financial crisis of 2008/09). Today, market-based inflation expectations in the UK have surged ahead, but this is a unique market where demand heavily outweighs supply, so we are reluctant to ascribe too much value to them.
Around the world, higher than average rates of unemployment are tempering underlying wage growth, which remains subdued, and far lower than the headline payroll measures suggest. In the UK, for example, after adjusting for base effects and the decrease in lower- wage jobs relative to higher-wage ones due to COVID-19, the annual rate of wage growth is under 2% rather than the 8% stated in the labour force survey.
Anecdotal evidence of labour market shortages abounds, but new evidence from Oxford Economics suggests they are concentrated in only four industries: agriculture, manufacturing, construction and distribution. They account for a relatively small percentage of employment. All other sectors in the UK are experiencing fewer abnormal mismatches between vacancies and available labour. The health sector aside, industries with high levels of vacancies are also the ones that suffered the heaviest job losses during the pandemic and, moreover, still have the most workers furloughed. This suggests that sector-specific labour shortages should ease once the furlough scheme closes at the end of September, as some companies will fold or downsize, freeing up labour for their more resilient peers.
"Labour shortages are unlikely to disappear entirely, either in the UK where the loss of immigrant labour is problematic, or in the US where an unusual number of people have taken early retirement."
Labour shortages are unlikely to disappear entirely, either in the UK where the loss of immigrant labour is problematic, or in the US where an unusual number of people have taken early retirement. We do expect wage inflation to increase, but not to a deleterious level.
Other supply chain bottlenecks are starting to ease too, but the evidence is mixed. PMI surveys asking about input prices (the average prices of all goods purchased) are back down to a level consistent with the upper end of the normal historic range of core inflation. Many commodity prices have fallen back from their recent peaks, some aggressively. US lumber prices, for example, are down 70%. These moves will start to feed through into the next inflation print: in early September they were down 40% year-on-year whereas at the beginning of August they were still up 2% year-on-year. Despite ongoing shortages in logic chips, generic semiconductor prices fell circa 20% in August (although they were still more than double the cost of a year earlier!). Yet, at the same time, supply bottlenecks are presenting upside risks to prices for at least another quarter. Shipping costs continue to spiral higher, while survey gauges of inventories are plumbing new lows.
In sum, we expect today’s high level of inflation to be transitory, but we stress again that transitory is an imprecise term. If expectations do need to readjust, this could engender bond market and equity market volatility.
Monetary policy round-up
The discussion around the fading out of central bank easing through tapering of government bond purchases (QE) continues. Tapering is almost universally expected at some point in the next six months, unlike in the 2013 ‘taper tantrum’ when it came as more of a surprise. Even in 2013, developed equity markets recouped their losses quickly. However, any future tapering may be more of a lasting issue for emerging markets.
Another big difference likely to forestall a disorderly response to tapering, when it does come, is the large amount of dollars in circulation. In other words, the market has immediate sources of liquidity to tap should it need to in a way not possible during past tapering or quantitative tightening episodes. This is through what are known as ‘repo’ facilities, which currently total over $1.5 trillion of funds.
"The monetary policy committee now expects inflation to peak above 4% this winter."
Turning to the UK, monetary policy may take a steeper path than most had expected. In its late September meeting, the Bank of England cited the burgeoning energy crisis and labour and material shortages as risks to ‘transitory’ inflation. The monetary policy committee now expects inflation to peak above 4% this winter. If employment figures are strong in coming months, it seems possible that the first hike could be in the first half of 2022. Gilt markets responded immediately, with the 10-year UK Treasury yield rising more than 10 basis points (bps) in a day to 0.91%. It has since broken through 1.00% for the first time since April 2019. Assuming the first hike is a 15bps increase to 0.25%, markets are fully pricing this in for the March meeting.
The debt ceiling dance
As we go to press, another debt ceiling standoff is brewing in the US as Democrats try to get their $3.5 trillion spending package pushed through a reluctant Senate.
We don’t see any reason to think this impasse will be any different from the many that have gone before. And if history is anything to go by, debt ceiling standoffs (or in the worst case even those that morph into government shutdowns) don’t make more than a blip on the charts of market returns.
Some strategists point to parallels with 2011 when a US government shutdown did cause equity markets to fall sharply. But this coincided with Greece asking for a second bailout during the eurozone debt crisis. Investors were worried about the whole eurozone breaking apart before the European Central Bank (ECB) intervened to stop Spanish and Italian government borrowing costs from soaring into the stratosphere. This was the scene of former ECB President Mario Draghi’s famous “whatever it takes” speech. We don’t expect such historic coincidence this time around.
Germany’s right-leaning alliance may have ended following Sunday’s parliamentary elections, where the Social Democratic Party led by Olaf Scholz narrowly beat the Christian Democratic Union (CDU)-led bloc under Armin Laschet, taking 25.7% and 24.1% of the vote respectively. Still, this isn’t likely to bring about sweeping change. All parties have become less fiscally conservative, so we don’t foresee a tightening of the purse strings. But we don’t expect any major stimulus either.
More than any other large democracy, Germany rules by consensus. This is down to the nature of the Bundesrat – a parliamentary chamber composed of delegates sent by the 16 ‘länder’ (states) The delegates from each state must agree on their vote, and if they can’t agree, it counts as a no. This means that political parties that may not be in power at the national level, but do have significant representation in state governments, effectively wield a veto power. The Greens, who are in a good bargaining position following the election, have had this de facto veto for the last few years. Former Chancellor Angela Merkel’s conservative CDU and its Bavarian sister party the CSU are likely to have this veto power as well if they don’t form part of the ruling coalition in the next government, which is a distinct possibility after Sunday’s results. This is all a long-winded way of saying that not much will change.
China’s heavyweight regulators
The recent regulatory onslaught in China could exacerbate headwinds from a lack of sufficient monetary and fiscal stimulus and a zero-tolerance stance toward COVID cases. But we don’t think second guessing Communist Party policy is a good idea. Nor is assuming that the Washington Consensus – free trade, free markets, low regulation – will prevail. South Korea and Taiwan, the greatest success stories of the later twentieth century, succeeded with corporatist and interventionist, not liberal, policies. And even in the West, the golden age of growth, the boom of the 1950s and 1960s, was a time of greatly increasing regulation. In other words, Beijing could hit a very profitable sector hard, flying in the face of popular Western economic principles, if it believes – rightly or wrongly – that the net effect of redirecting capital elsewhere would be beneficial.
Most importantly, investors shouldn’t ignore what Beijing is telling them! The clampdown on ride-hailing company Didi followed naturally from the sweeping Cybersecurity Law passed earlier this year. Beijing has also been very clear for a couple of years that it doesn’t want the service sector share of the economy to grow to larger than it is already at just over 50%. This was reasserted in the ruling party’s 14th Five-Year Plan, which was released in April. And it doesn’t want to de-industrialise because it believes that to do so would worsen social inequality and would hamper efforts to propel the nation out of what’s known as the ‘middle-income trap’. This is a common phenomenon in developing nations where they lose their competitive edge in the export of manufactured goods due to rising wages. Countries in the middle-income trap are unable to transition to a higher-technology, knowledge-based economy.
As part of its long-term reforms, China has been battling a dangerously inflated property boom for many years now. Developers borrowed heavily from global investors and Chinese households to throw up countless homes all over China. Demand for these homes, both as abodes and investments, was huge. But many companies have overstretched, repaying maturing debt with ever more debt as they chased sales growth. This is nothing new, but it has finally come to a head with Evergrande, China’s largest real estate company, which has hit a cash crunch because of new regulations aiming to stop runaway house price inflation and encourage developers to become more financially responsible. It has somewhere in the region of $300 billion in debts, mostly to local tradesman, would-be homeowners and retail investors through investment products. This is a messy situation that will take some unwinding, bringing concerns over the inevitable slowdown of the property sector to the forefront. However, there is little risk of financial market contagion inside or outside China, and any volatility we see outside of China is likely to be short lived.
Good COP, bad COP
Looking ahead to the next quarter, all eyes will be on November’s COP26 climate summit in Glasgow which brings together representatives from nearly 200 nations. They meet against a backdrop of calls for urgent action on climate change and hopes that this will prove to be a ‘good COP’. Progress since the COP process was born in 1994 hasn’t followed a straight path. Our latest Planet Paper Good COP, bad COP takes a look at some of the most notable COPs, good and bad, to help us work out what’s needed from this next gathering to make it a good one.
Reasons to stay cheerful
As many of us begin to ease back into our office chairs, we can’t pretend to be sitting particularly comfortably. As we continue to emerge from the pandemic, a lot of things are looking a lot more uncertain than they were at the start of the summer.
But all things considered, we don’t think the rebound is stalling. Far from it, we see global economic growth staying buoyant versus its pre-pandemic norms. As we go ‘from great to merely good’ we do think this will be good enough to support continued growth in corporate profits and further gains in global equity markets and other risk assets.