Normally I end this section with a table of economic forecasts, but I thought I’d go front and centre instead, to show the magnitude of the damage done to global economies by the pandemic and how varied this has been across geographies. Normally I use consensus forecasts from the great and good, but these are all over the place so instead I’ve used the recent projections from the OECD, whose forecasts also include outcomes in the added scenario of a second wave of infections. Several things leap off the page, amongst them are that the UK and Europe have been the worst hit, with France, Italy and Spain being similar to the UK and that those fearing a new era of inflation are being premature.
This raises the question as to why we Brits are bringing up the rear, especially as the year began in pretty good shape with hopes of a ‘Boris bounce’, unemployment at rock bottom and a pick-up in wage growth. The reason is twofold; the shape of the UK economy and our inadequate response to the pandemic. The UK economy is amongst the most service-based in the world, nearly 80% according to the OECD with trade, hospitality, tourism and retail amongst the sectors worst affected by COVID 19. The UK’s slow initial response to the pandemic exacerbated our problems as it has meant a longer lockdown whilst the execution of the gradual easing of restrictions is not giving the impression of a government at the top of its game. Asia and much of Europe are back on their feet already, whilst we are still tentatively taking our first steps and consumer and business confidence is going to take a long time to recover, ‘scarring’ being the economic buzzword for this.
As I’ve frequently said, two of the great curses of portfolio management are paralysis by analysis and taking misplaced comfort in forecasts which are almost certainly going to be wrong. Thus, I’m going to spare you paragraphs agonising over the path of growth quarter by quarter. All current data is ‘the worst ever’ by any measurable standard but this is old news as far as the markets are concerned and already baked into prices. What matters is the trajectory of growth as lockdown restrictions are eased, which is where the speculation comes in and I leave the debate, stressing only that no-one has much of a handle on how this is going to play out over the next two years.
Public Enemy Number 1
There is a fierce intellectual battle taking place as to whether deflation or inflation is the greatest risk to the global economy. The monetarists say that there is now so much liquidity pumped into the system that there is a coiled spring of pent-up demand which will result in rampant inflation once the recovery begins. They postulate that QE, this time, is nothing like in 2008 as it will go directly into the real economy rather than just prop up the Banks who did not lend last time out. Those running the show in government and at the Central Banks disagree, saying that it will take years for consumer spending to fully recover, for firms to rebuild their balance sheets and for new jobs to replace those permanently lost. UK CPI was just 0.5% in May and it’s going to be a long time before it starts to run away again.
Jerome Powell was particularly dovish at the Fed meeting a couple of weeks ago, saying ‘“We are not even thinking about thinking about raising rates” The implication is that interest rates and bond yields and are going to remain anchored near zero in the US, UK and elsewhere for the next few years. For inflation to prevail there needs to be no second wave of infections and a ‘back to business as usual’ style recovery. This could happen of course, but it would still be tomorrow’s battle and we will have plenty of time to reconsider our view that, for now, deflation is top of the FBI’s Most Wanted List.
With the UK base rate at just 0.1%, the Bank of England is faced with the question of whether to take rates negative. The experience of Japan and Europe shows that an extended period of negative rates has not been successful in revving up the economy and that once you’re below zero, you tend to stay there. Negative rates pose a huge problem for banks and building societies who rely on customer deposits for funding. If they reduce deposit rates below zero, they will scare savers away; if they maintain deposit rates but reduce their lending and mortgage rates, their margins will be crushed even further. A flat yield curve is the enemy of bank profitability. The Bank of England may be creative as it was in 2016 with the Term Funding Scheme which pumped cheap funds into the Banks to make sure they passed on the cut in base rates, but we think base rates have gone as low as they can. Rather than taking rates negative, the BoE will likely stick with the ‘yield curve control’ approach used by the Bank of Japan and being considered by the US Federal Reserve, which is to keep ramping up their purchases of gilts and target a formal cap on long-term yields.