Updated: Mar 9
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An update on where I think we are in the business cycle with respect to growth, inflation and markets
I haven't written for a while about what has been happening on the economic and markets front. This is largely because little has changed, whether in my head or outside it.
Inflation came down a bit from its peak, but there is now more talk about it being "sticky" (bond yields have bounced, following declines). My view, as I have documented clearly in recent months, has been and still is that inflation would fall a bit (perhaps to mid-single digits) as a result of some sort of recessionary environment, then bounce back because central banks prioritised growth over inflation (implicit abandonment of 2% targets).
However, the recent movements in inflation and bond yields have nothing to do with recession expectation and related reduction in interest rates (interest rates are still rising!) We still have those to look forward to, though when they might happen is anyone's guess.
While the fall in bond yields in January may have been due to the easing in inflation in many parts of the world, the bounce back reflects the reality that economies are still running hot (inflation may have fallen slightly but it remains high).
Why have economies not slowed in response to the increases in interest rates across the world? There are a few reasons:
1. although high inflation lowers economic growth and is thus fundamentally bad, there will always be those who benefit from it along with those who suffer (a cost rise for someone is a revenue rise for someone else);
2. consumers are still running down savings that they accumulated during lockdown either as a result of fiscal stimulus or lower spending on travel and entertainment;
3. it is possible that consumer debt defaults are now increasing but are being absorbed by banks and thus not "spilling over";
4. although interest rates have been increased greatly over the last couple of years, they may still not be high enough to cool economies;
5. nominal wages are now rising at high rates - this helps consumers deal with high inflation but it does not cool the economy or indeed bring down inflation;
6. economies do not behave linearly. They hit tipping points at which things start to change rapidly, increasing unemployment being a key one. We have simply not hit this tipping point yet.
In relation to 2. above, consumers in the UK during the height of covid (March 2020 to February 2021) paid down £14.7 billion of credit card debt. Since February 2021 credit card debt has increased by £12.1 billion (see Chart 1 below). In other words, there is still scope for increasing credit card debt to sustain consumer spending for a little while longer, though of course higher mortgage rates will also be limiting consumers' ability to spend (as indeed will higher interest rates on credit card debt be limiting scope to borrow more).
Source: Bank of England
As for point 3. above, it was reported recently by Credit Strategy that, "More than 18,000 new StepChange Debt Charity clients completed full debt advice in January 2023, which is at least 22% higher than any single month in 2022. This stark data suggests that more and more people are struggling with debt in the new year following almost 12 months of rising living costs."
Of course there are still many who think central banks can engineer soft landings. I suppose that is still possible but soft landings are rare. Throughout history, the only things that have really ever brought down high inflation are hard landings.
Thus, we appear to still be in the peak phase of the business cycle in which interest rates rise in response to rising inflation but have not yet caused a meaningful growth slowdown or, worse, a recession. Equities and bonds behave poorly during this phase as rising/high inflation hits bonds, and equities are hit by higher real interest rates (this impacts equities' valuation) in response to rising inflation and the anticipation of a meaningful slowdown caused by higher interest rates (this impacts earnings).
Gilts have hardly started to perform well, and could well resume their declines of the last couple of years if inflation turns out to be stickier than previously thought, wage demands persist, etc. As for equities, ignore the talk about the FTSE 100 being close to all time highs. A high proportion of earnings from FTSE 100 companies comes from overseas so the index does not reflect the domestic economy. And remember that the high inflation over the last two years has eroded the purchasing power of both equities and bonds. The 14 per cent rise in consumer prices that we have seen since the end of 2020 would turn a 7% increase in nominal equity or bond values into a 7% decrease in real terms. And spare a thought for those poor overseas investors in UK equities and bonds who have lost further real value because of sterling's weakness in recent months and years.
Conclusion? Continue to keep some powder dry. We have yet to see the worst of the peak phase.
In relation to Chart 1, a reader asked how the data would look if it was adjusted for inflation. This was an excellent question, as I bang on about the importance of making that adjustment - I should have explained that it would not have changed anything i.e. that inflation-adjusted numbers would still have suggested there was scope for further credit card borrowing to sustain consumer spending. Nevertheless, the below chart presents both nominal and inflation adjusted numbers, and shows that based on inflation-adjusted numbers, the case for spending being sustained is even stronger. Note that the below pertains to amounts outstanding (rather than monthly changes as in Chart 1 above) and so includes writedowns (which Chart 1 above doesn't).
The important conclusion is that while it may be tempting to think that it is a good thing that economic growth is sustained, it isn't. Sustained economic growth just means that inflation stays high, which means that interest rates have to rise even more, which means that performance of bonds and equities in real terms during this peak phase will be even worse. Be careful what you wish for....
Source: Bank of England
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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