“Be joyful, keep the faith”
As we move out of summer and the early signs of autumn show their hands through a dusting of browning leaves on the grass and a crisper chill in the morning, I look back with great thanks at the wonderful coastline and people of Pembrokeshire for a fabulous week in the sun and look forward to visiting again. The City of St David’s is one of contrasts; a village, more than city, with its primary landmark the cathedral and place of worship for over 1500 years, tucked out of site almost hidden to the casual visitor. St David’s last words were said to be “Be joyful, keep the faith, and do the little things that you have heard and seen me do”.
Central banks have recently been heard to have been saying something similar.
Fragility, yes. Complacency, no.
We are moving in to ‘tricky second album’ phase of the economic recovery. After a swift and strong recovery in momentum up to this point, there are increasing signs of fragility in the continued pace of recovery. Whilst the initial economic rebound from last year’s shutdown was swift, continued recovery faces the headwinds of the Delta variant and supply bottlenecks, both of which stand to suppress growth. Whilst above-trend growth lies ahead for this year and next, these forecasts have edged lower of late, with even the revised forecasts more optimistic than reality, with the UK economy eking out just 0.1% growth in the month of July compared to the forecast 0.6%. There was a noticeable drop in US consumer confidence through August in the face of rising cases of the Delta variant as well as rising oil and food prices. In the UK, savings ratios have come down from their peak but remain far higher than their long-term averages, which suggests some continued caution remains amongst consumers in their own spending habits.
The strong recovery causes problems for central banks, particularly the US Federal Reserve, which finds itself in the awkward position of having a recovery that looks further ahead than the emergency funding state that policy setters have in place. The dual mandate of the Federal Reserve is to target both inflation and full employment and it is clear the latter of these two are the primary focus for policy-setters at present as inflation numbers creep higher and policy remains ultra-loose.
Rising taxes, lower growth?
The hugely significant announcement that National Insurance is going to be raised by 2.5% (split 50/50 between employees and employers) in order to raise £12 billion to arm the NHS with a budget to tackle the backlog of patients and then be directed towards social care comes with questionable economic timing. There’s no doubting the importance of tackling the issues of both the NHS waiting lists and the stresses and financial challenges of social care, but the timing of such a significant tax rise in the early foothills of an economic recovery, places an additional hurdle for the economy and will weigh on the outlook.
In some ways this echoes the issues Japan faced when raising consumption tax in 2014 which did two things. Firstly, it dragged forward spending as consumers tried to get ahead of the rise (this will be less relevant given National Insurance is levelled against earnings, not consumption. That said, the reduced rate of VAT being applied in the leisure and hospitality sector ceases at the end of September so we’ll see some impact here). Second, it suppressed growth and, in the case of Japan, pushed it back into recession.
The coming tax rise combines with an increased likelihood the Bank of England will begin raising rates, and the winding down of government furlough schemes in an environment of already slowing growth numbers. From an economic standpoint these tax rises, however deservedly spent, will combine with increased energy bills and food costs to place an extra burden on the UK consumer.
Still good times ahead
With all the fears about the Winter of Discontent 2.0, some of the good news gets lost in the noise. Whilst central banks may be tentatively beginning the process of reducing support, we still have a very positive backdrop for asset markets. Fiscal support will remain the primary tool for policymakers and it is a tool they are prepared to use in massive size. In Biden’s Presidency we have already seen a $1.9 trillion American Rescue Plan and negotiations are ongoing about a further $2 trillion for infrastructure spending. We can look forward to continued growth and asset markets will undoubtedly suffer from bouts of volatility but are still likely to keep moving forward on this wave of stimulus.
In addition, the consumer remains in a healthy position with elevated levels of cash on household balance sheets, whilst almost any asset held has seen significant price growth over the last 18 months or so, whether that is in residential house prices, bonds or equities. The positive wealth effect will encourage spending when supply shortages and further hold-ups from the pandemic clear.
So, whilst the near-term outlook for growth has weakened, it remains strong with pent-up consumer demand and still a very supportive policy backdrop from governments as well as central banks. Corporate health is similarly well-placed on several measures whether that be in earnings or on improving balance sheets. On balance, whilst we have moved past the first stage of the recovery, we are not on any downward slope yet and fundamentals remain intact.
Growth & Inflation Numbers
Whilst the initial economic rebound from last year’s shutdown has been swift, continued recovery faces the headwinds of the Delta variant and supply bottlenecks, both of which stand to suppress growth. Whilst above-trend growth lies ahead for this year and next, these forecasts have edged lower of late. As ever, with many thanks to our friends at Schroders for these latest consensus forecasts.
Inflation is much talked about and needs to be watched as supply disruptions are becoming more stubborn and taking longer to resolve than anticipated. Transit and raw material costs may well begin to alleviate as supply chains re-establish and we get through Christmas, but what remains in question is how much wage inflation will become embedded as we go through annual pay rounds across the economy as a whole, beyond those where wage rises are being driven by an immediate and acute shortage of labour.
A more sustained inflation problem is not what we are seeing yet but should not be discounted for now as inflationary numbers are proving stickier and persistent. Transitory remains the inflationary buzzword and remains our base case and sitting on the fence and watching closely rather than taking a binary position remains the sensible course of action for the time being. There is no doubting the headlines make for ugly reading with gas prices soaring, petrol not being delivered, the government calling for increased pay and better conditions and the Bank of England anticipating 4% inflation into the early part of 2022. Changes in consumer behaviour, ongoing quarantines, disrupted energy markets and a misallocation in our labour supply are all consequences of the sheer economic upset COVID-19 has caused. These issues will be surmounted in time, but more time is going to be needed.
Despite US equity markets making headlines for hitting new highs earlier in the quarter, continued strong corporate earnings growth through 2021 means they are slowly creeping into their still elevated valuations. We do not feel exuberant but believe forecast strong economic growth and the continued strength of corporate earnings offers some option for this process to continue.
There remain areas of concerns for markets to grapple with. Stickier than anticipated inflation numbers caused by the signs of early wage increases to try and tempt workers back into the jobs market as well as supply disruptions created from the economic restart. There is a conflict between countries with well-developed vaccine programmes with consumers ready to spend again, compared to countries with large manufacturing bases, particularly in Asia, that are suffering virus setbacks and seeing increased restrictions on movement.
In fixed income, we remain very wary of long-dated bonds given the likelihood of rising yields in the coming quarters, which would result in declining prices. The corporate credit market still has very many strong fundamentals to warrant attention, low default rates, high demand and strong corporate earnings all make for an attractive backdrop, but the significant contraction in both yields and credit spreads have driven valuations to very high levels.
The ‘lower for longer’ interest rate narrative continues, with no rise in interest rates until late 2022 in the States and further out for the ECB. The Bank of England may move earlier than both but a slowly rising rate environment, with a lower terminal rate, remains our base case. Overall we have sought to shelter our fixed income holdings in strategic bond funds and short-dated fixed income funds to limit the effects of rising yields.
In equities, valuations in the US look relatively expensive but in this low rate environment investors remain prepared to pay up for accessing the more dynamic corporate environment and its continued strength. Elsewhere valuations look less expensive but are not cheap. We continue to retain a balance of equity exposure across sectors and geographies and have no immediate plans to change the current balance.
Conclusion – Time is on my side.
As we move towards what could be a difficult winter, there are plenty of concerns that we need to keep at the forefront of our minds. Covid and Covid-related restrictions are not going anywhere soon and stresses in the Chinese property sector combined with tightening regulations in other sectors pose challenges too. Markets will also need to navigate their way through the lifting of the US debt ceiling and the ongoing supply disruptions that continue to make headlines. This all before we get to the end of the quarter to find Christmas has been cancelled!
Despite all this, there are plenty of reasons to remain true to the belief markets can continue to move forward. Economic growth is still positive, governments and central banks are still in ultra-supportive mood, corporate health and earnings are strong and the consumer has cash ready to spend. Retaining a diversified portfolio and looking through near term volatility is a strategy that has served investors well through the years. So, as St David said, “Be joyful, keep the faith”.
We continue to wish you and your families well.