Pay them and they will come?
The needles on the indicators of investment sentiment are all pointing down. Inflation, potential monetary tightening, fiscal uncertainty, and slower growth in the world’s second biggest economy are all in front of our eyes. I never like to say what is or is not priced into markets, but I am concerned that sentiment could get worse. In the UK, the stewardship of the economy is being driven by a combination of failed supply side economics, what appears to be disdain for business and a central bank hawkishness that might be misplaced.
You can’t knock UK Prime Minister Boris Johnson for trying to put a glossy spin on things that look bad. His take on the supply problems afflicting the UK economy is that they are a combination of the global economy getting back to health and the post-Brexit UK economy adapting to a new economic model. That is one, in his words, where large-scale immigration no longer undercuts wages (and therefore living standards) but encourages the evolution to a high-skilled, high-wage economy in which British workers become more productive and higher paid. The message clearly resonates with some categories of voters, but it is economic nonsense. For investors, it is also dangerous as it may encourage some un-anchoring of inflation expectations and lead the Bank of England to make a policy mistake.
Open versus closed
Economists will argue that open borders, free trade and exploiting comparative advantage all add to national welfare. If trading partners can supply goods, resources or labour that is cheaper and / or more productive than what is available domestically, then nations should accept that. The failed import-substitution models followed in many emerging economies in the 1960s and 1970s and provide ample evidence of errors of the contrary approach. However, openness has a political reality. If the UK consistently favoured German cars over British made ones – because they were better – the consequence is that the British car manufacturing shrinks. If Polish builders are cheaper, more efficient and less prone to taking “sickies” then local builders don’t get the jobs. The political consequences fuelled Brexit and, with some parallels, Trumpism in the United States. For a more academic take on the impact of immigration on the UK economy, please take a look at the following: New evidence on the economics of immigration to the UK. Spoiler alert, immigration has not cut the wages of native workers and has added to productivity. Not the message from the current UK government.
Higher inflation, lower output
The UK economy is facing the double-whammy of supply bottlenecks and inflation coming from global developments and those that can be traced to Brexit and the large number of EU citizens that worked in the UK no longer being there. The true picture is complicated by a lack of investment in skills and poor working conditions. It is also clear that there is limited substitutability – otherwise all those vacancies created by EU workers leaving would be being filled quickly by domestic labour. The most likely economic outcome for the UK will be continued labour shortages and, therefore, disruptions to the supply of goods and services (Christmas at risk again!), higher wages as firms try to fill open positions and no discernible improvements in productivity (as my colleague Gilles Moec pointed out to me, the productivity of picking raspberries does not improve whether the picker is from Romania or Kent).
Higher domestic energy prices, regressive shifts in the tax and benefits system and disruptions to supply and output don’t usually create the conditions for raising interest rates. Yet, that is what is being discussed by the Bank of England and some market participants even suggest a rate hike could come before the end of this year. It is true that since 2016 the UK has not undershot its inflation target in quite the same way we have seen in the US and in the Euro Area. A weaker pound in the wake of the Brexit vote was instrumental in that. The BoE hawks would argue that the lack of inflation undershoot makes it more likely that inflation will overshoot now and become embedded for the medium term. Therefore, the risk is that rates are increased sooner rather than later.
Longer term, more productivity and flexibility
Luckily the Bank is only talking about modest increases for now. The market has the Bank rate still at 0.5% by the end of 2022. But the outlook is unclear and monetary policy is a fairly blunt instrument if underlying inflation problems are coming from a lack of productivity and flexibility in the economy. Official data show reduced numbers of workforce jobs in certain sectors that can’t be reversed quickly especially when, in the case of heavy goods vehicles drivers for example, it is not just the absence of European drivers but a reduction in the attractiveness of the job, the high cost of training and the length it takes to get a licence.
No place to hide in sterling at present
The risk scenario for the UK is that policy tightening – fiscal and monetary – and the supply squeeze undercuts growth going into 2022. With gilt yields above 1% there is negative momentum in the bond market, being driven by break-evens inflation rates and higher interest rate expectations. At some point the rise in rates will look somewhat incongruous with the macro risks. The other part of the story could be a decline in sterling if investors focus on a less well performing economy and a more toxic political atmosphere. At the moment the pound is going up on interest rate risks, but that can surely only be a short-term knee jerk reaction.
Threats to risk
Globally, I stick with my view that the biggest threat to markets is from the supply side disruptions and their impact on near-term growth and earnings. But there remains plenty of liquidity and investors have cash to invest. The ‘buy on the dip’ mentality amongst investors could persist to limit any downside. Nevertheless, volatility is higher, and I would expect that to remain the case. The macro backdrop is just not as clean as it was in the first half of the year. Higher materials prices bring the risk of margin squeezes. Revenue and earnings estimates are at risk of being moved lower. Real rates are rising but this is not necessarily a signal to buy all value stocks as some of those industrial cyclicals that did well in Q4 and Q1 don’t have the same narrative today. Bond naysayers will have it at these levels of yields, Treasuries and such don’t provide much of a hedge. I dispute that and if risk does crack, we could see bond yields heading back to the bottom of this year’s range. One should also consider that once the inventory shortages are addressed over the next few quarters, the next concern might be oversupply and a resurgence of deflationary pressures, especially if the policy environment is tighter.
Overall, I sense less confidence amongst investors over the near-term macro outlook and less confidence in policy makers. The Fed is under political scrutiny and will see significant personnel changes. There is still no resolution to the debt ceiling issue. Fossil fuel energy capacity is constrained when we are reducing financing to that sector. It’s all a far cry from a rapid recovery, boosted by fiscal largesse and free flowing liquidity seen in 2020. The disappointing increase in September’s non-farm payroll number (194k versus the market estimate of 500k) is another sign of the tensions. This is an environment that deserves more caution for a while.