Monthly Commentary March 2018
Inflation down rates up
The latest data show that inflation is starting to fall and yet the Bank of England are poised to raise interest rates. Given that interest rates are normally expected to rise as inflation rises, why is this time different?
Firstly, we need to note that the Bank of England set policy rates in order to hit their inflation target in two to three years time. Secondly, we need to consider why inflation has risen; this will help add context to the debate.
Inflation has been increasing since sterling fell significantly in the wake of the vote to leave the EU. In order to import the same amount of goods it has been necessary to pay more for them in sterling terms, and this has had an impact on the overall price level in the economy. This increase in inflation had little to do with the state of the domestic economy, and it is therefore difficult for policy makers to tackle directly. If you cast your mind back to the financial crisis of 2008, you will recall that the Bank of England’s response to the then increase in inflation caused by the fall in sterling was actually to cut policy rates, reflecting the underlying weakness in the economy.
Policy makers try and distinguish between what they call first and second round effects. Examples of first round effects are: a depreciation in the exchange rate, an increase in indirect taxation or an oil price shock. First round effects are typically externally influenced events which local policy makers can do little about. Second round effects are reactions to first round effects. For example, when employees demand increased wages to offset increases in inflation. Policy makers are in a much stronger position to mitigate second round effects. This explains why as inflation was rising the UK’s Monetary Policy Committee did not increase interest rates, and now that sterling has stabilised why inflation is falling. However, it does not explain why the MPC is now looking to increase the policy rate – for this we need to look at longer term structural issues within the UK economy.
Paul Krugman, the Nobel prize winning economist said that “productivity isn’t everything but in the long run it’s almost everything.” Productivity in economic terms is the amount of output that can be produced with a given level of input. Since the financial crisis the UK economy has grown steadily if unspectacularly. This growth has gradually eroded the amount of spare resources in the economy to the point that unemployment is at historic lows and firms are believed to be producing at close to full capacity. In turn this means that any further economic growth may be inflationary as firms’ bid-up’ prices of scarce resources. Once an economy has reached full capacity it is possible to grow further without generating inflation but only if productivity increases.
“Productivity isn’t everything, but, in the long run it’s almost everything.”Paul Krugman
Unfortunately, UK productivity has grown extremely slowly over the last 10 years, the causes of which remain somewhat of a mystery. This ‘productivity gap’ means that the amount of growth that can be sustained without inflation is lower. Hence the explanation why policy rates are expected to rise in the future: we can no longer grow the economy without generating inflation.
We are experiencing the intersection of two different trends: downward pressure on inflation today caused by the unwinding of one-off effects, and upward pressure on anticipated inflation caused by structural changes.
It seems that we are entering a time of heightened uncertainty. The current business cycle is already almost a decade long and central bank balance sheet expansion may be coming to an end. As we saw last month, such a situation can create volatility. Volatility can generate the opportunity for good returns, but it is also true that correlations between risk-seeking assets increase with volatility. Diversification still offers some protection, particularly if that diversification is across different types of risk premia. Investors need to be disciplined enough to ride out periods of volatility – remember the long term is your friend- yet also be nimble enough to take advantage of opportunities through quick decision making and timely execution.
UK year-of-Year CPI inflation
No news might be better news.
March became the trade flashpoint for the world’s two largest economies, rocking global equity markets with fears of a trade war.
The US administration initially announced 25% import tariffs on foreign steel and 10% on aluminium. This was followed by a 25% tariff on $60 billion worth of Chinese imports. In reply, the Chinese fired back an increase in tariffs affecting $3 billion worth of US imports. Unsurprisingly, in March the UK, US, Europe and emerging markets all had negative equity returns of c. -4% to -2% in sterling terms, including a partial impact of strengthened sterling (we comment upon the causes of this later).
The big question is: what next? Presidents Trump and Xi have both staked their political futures on making their nations “great again”. But it is important to contextualise the size and importance of any protectionist measures that have been imposed. The proposed tariffs on Chinese goods amount to only about 0.1% of Chinese GDP while those on US goods are even less significant for US and global growth. That is not to say that risks to the trade outlook do not exist, but we think that these two economies are so intertwined and interdependent that they simply must find ways of getting along. Therefore, we do not think that the underlying fundamentals of healthy global growth and accommodative monetary policy have changed enough to justify a more negative outlook for equity markets over the rest of this year.
In the UK, March brought us relatively good news including improving real wage growth, thanks to falling inflation, and low unemployment, combined with the recent good news that a Brexit transition deal has been finally agreed. We believe this is likely to give the Bank of England (BoE) the confidence to raise rates again in May, tightening monetary policy in the UK, albeit at a pretty glacial pace. However, the net negative sentiment on global equities was such that yields fell rather than rising as would be expected from confidence in monetary tightening, meaning that pension schemes which were unhedged on interest rates would have seen funding levels hit by a double whammy of rising liabilities and falling assets. The main risk to the UK economy though seems to be stalling/falling house prices and the potential impact on consumer confidence. Home values fell for a second straight month in March and the BoE reported bigger-than-forecast decline in mortgage approvals. For the time being however, we think it is worth monitoring the housing market but it is not yet a cause for serious concern.
In the US, key indicators for the economy, such as elevated consumer confidence and increased job openings, continued to paint a positive picture for the growth outlook. The US Federal Reserve (Fed) shifted their expectation of an increase in US interest rates higher but this did not save the dollar from weakening. The culprit was the market forecasting an increase in importing by the US as a result of higher spending so that it can finance its stimulus. In other notable news, the Facebook/Cambridge Analytica scandal rocked the technology sector, wiping 15% off Facebook’s value and impacting US indices as a whole (in particular market capitalised indices). Yet the backlash against technology was not solely about the specific data integrity issue and we expect regulatory burdens to increase on the sector as a whole (Trump’s Amazon tweets notwithstanding).
The end of March and the first quarter of 2018 can be best characterised as the return of volatility, and we expect that this situation will persist for the rest of the year. Given the bull run of 2017 (and prior years), investors have become somewhat sensitive to negative news, which can hit sentiment hard. When we look at the big (data) picture we see no need to change course, yet it is clear that the perceived risk of something derailing these conditions has increased.