This is not normal
There are elements of this business cycle that are familiar: Tight labour markets, inflation, and monetary tightening. Yet many of the dynamics are unique. During the pandemic, global GDP fell and then recovered at the fastest pace in living memory. Since then, inflation has been at its highest in a generation. It would be optimistic in the extreme to think everything could normalise quickly, especially given the risky geopolitical backdrop. So investors might continue to be surprised as they face short-term uncertainties on inflation, interest rates, and growth. The good news is that science is potentially going to deliver better, cleaner, more sustainable growth in the future. There is money to be made from the next phase of the industrial revolution.
It’s increasingly evident that this is not a normal business cycle. It is hard to forecast and there is plenty of room for surprises. There are three big themes that we need to continue to try to understand. The re-setting of monetary policy; continued shockwaves from the pandemic; and the growing long-term thematic of the dominance of science over finance. All have major implications for the current cycle, for future growth and inflation, and for financial markets.
Inflation and rates
Inflation is the symptom of imbalances resulting from years of monetary largesse and the supply and demand disruptions that followed the pandemic and the Russia-Ukraine war. Inflation since last year has necessitated a paradigm shift in monetary policy. Economists, financial market participants and central bankers do not appear to know when this shift will be complete and what the eventual implications will be. Central banks have become more reactionary, with officials admitting that they are following the data. They misjudged the increase in inflation in 2022 and are nervous about whether it will come down enough. As a result, any inflation release deviating from the idyllic path of a quick return to the pre-pandemic utopia of a global 2% rate means central bankers become more hawkish and the market prices in another notch higher in terminal interest rates.
Higher and higher
Since the last round of rate hikes at the beginning of February, the market-implied peak in rates across the US, Europe and the UK has gone up by 25-50 basis points. Unless we get softer numbers, I imagine there will be a similar response after the next round of central bank meetings in mid-March. Each incremental increase in official rates is likely to be met by the market pricing in another one or two increases thereafter. A pivot can only be a pivot if the central banks say it is – softer data on prices and labour markets and central bankers willing to say rate rises are done. We don’t appear to be quite there, but it is what markets crave.
Negative bond returns in February
Yields have risen, creating some negative total returns for bond investors after a very positive January. Yield curves are still negatively sloped and the forward market for overnight interest rates has the medium-term equilibrium rate settling at between 3.5% and 4% for the US and UK markets and around 3% for the Eurozone. That is lower than where we are today but well above pre-pandemic interest rate levels. Also, the decline in central bank reserves and tighter bank lending standards is causing broad money growth to collapse. The range of outcomes - from under-tightening in the face of under-estimated inflationary pressures, to an overly restrictive policy mistake - is wide.
Lower but bumpy
Inflation should continue to decline given lower energy prices, reduced supply chain issues and weaker economic activity in some areas. But labour markets remain tight which creates the risk of higher wage growth. Wages are the most important cost to many companies and higher wages can eat into margins, meaning lower profits. That implies less capital to finance growth and potentially lower investment returns to listed equity holders.
Last year, the monthly increases in consumer price indices (CPI) were well above the average of the previous 30 years. These need to come down. So far, we have had January CPI data, and it remained well above the historical average for January, certainly in the case of the US. Unless the monthly inflation numbers normalise, the annual rates won’t come down to the pre-pandemic 2% level for a while. More importantly, it keeps the routine of central bankers’ hawkishness prompting higher rate expectations going. Eventually that will hit credit and equities because it will be harder to talk about “soft” or “no” landings the higher interest rates go.
There are still aftershocks from COVID-19. These are most visible in labour markets where there remain shortages of workers and where participation rates have not fully recovered. Many parts of the economy were hit hard by the lockdowns in 2020 – in healthcare and in hospitality, staffing levels have only just returned to February 2020 levels, according to US Bureau of Labor Statistics data. Changes to how we work accelerated during the pandemic, so it is not clear that the data we look at today really reflects the true dynamics in labour markets. Anecdotally, there seem to be labour shortages and inflationary wage increases. In the UK, Brexit partly explains that. Elsewhere, COVID-19 is a common factor. Whatever it is, businesses and governments need to respond. It implies investing more in automation. It means a need to contemplate policies that might impact on the supply of labour – tax, training, welfare, and immigration.
The pandemic, the energy crisis and the resulting shift in global monetary policies continue to cloud the economic outlook. Throw in geopolitical trends and it becomes even more challenging. All these things interact. Supply chains were disrupted by the pandemic, making companies think hard about logistics and security. Deteriorating superpower relations have added to those concerns. This is real because it has become policy – the US has legislated to impact the supply of technology to China. For US technology companies that had used China as a cheap manufacturing location for products designed by US intellectual capital, the business model is under threat. It is also the first anniversary of Russia’s invasion of Ukraine. Energy prices have come down to pre-war levels, but political risk has increased, forcing governments in the west to devote more fiscal resources to defence.
There are positive structural changes though. Several technologies could generate massive changes to the global production function either through reducing costs or boosting productivity - or both. The combination of the need to combat climate change and the speed at which COVID-19 vaccines were developed has elevated the role of science over finance. That should mean the more efficient deployment of capital going forward. I have written before of a world in which clean energy, derived from the sun and the wind, has enormous benefits for consumers and businesses (the democratisation of the energy system) while reducing the constraints of dependence on fossil fuels that have all too often been weaponised during periods of sovereign conflict. Technological developments to take advantage of clean energy are rapidly developing and showing up in enterprise spending and government industrial policies. There may be a slightly distasteful aspect to this – policies dictating minimum levels of local content and subsidies that look like state aid – but the outcomes can only be beneficial for some time. A fact that caught my eye this week is that the price of a basic Tesla electric vehicle, because of falling production costs for batteries and government subsidies, is now lower than the cost of the average internal combustion engine car in the US - and by some margin.
Equities, science, growth
The development of new drugs through the advancement of biotechnology; the further automation of logistics chains and transport networks, as well as production facilities; and the application of artificial intelligence through many parts of the service sector are hugely exciting developments. The flow of capital into these activities has started and will accelerate and the gains could be exponential in terms of economic welfare. The global economy has been hit by numerous shocks in this century, but science can deliver more resilience going forward. Capital flowing to technology drives a more efficient use of natural resources, improves human welfare through better healthcare and reduces the risk of conflict over energy resources. This should be rewarded more than that which supported ever more complex financial structures, where the underlying economic cash flows were very hard to identify.
China to experience the post-COVID-19 boom?
These are all high-level observations but sometimes it helps to turn off the screens, ignore market commentary and think about the real world. We face lots of short-term uncertainty. However, what we know is that interest rates are higher and that means you can potentially earn more on investing in relatively low risk financial assets. The bond market offers relatively high yields. Most of the return from investing in bonds comes from income, especially on short-duration strategies. So higher yields tend to support income-focused strategies when growth is uncertain, as it is today. Looking further out, credit – as I banged the drum for last week – is attractive because rates will peak soon and if the long-term prognosis for interest rates is correct, there is a huge credit risk premium to potentially benefit from.
On the theme of the post-COVID-19 economy, among global equities China looks interesting. Everywhere else saw a massive increase in corporate earnings as economies recovered in 2021-2022. China’s listed companies have seen flat to negative growth in earnings for over five years. The reopening and more growth-focused policies could generate an earnings boom and the potential for very strong returns to investors in that market.
Growth for the long-term
The longer term should be about growth. Structural changes will provide growth opportunities. Decarbonisation technologies are becoming cheaper and more subsidised, meaning they will experience strong growth as the world adapts to net zero. The accelerated adoption of artificial intelligence will boost software services and technology manufacturing along the value chain and boost productivity for those enterprises that are able to adopt and use it. Whatever one thinks about cryptocurrencies, digitalisation still has a way to go in the provision of financial services, smart contracts and, where the political will allows, the more efficient delivery of public services from tax collection and rebates to healthcare and education. There are several household-name technology companies that have demonstrated non-linear earnings growth over the last 20 years. That will likely happen again. Look to where those non-linearities might occur. The science will help more than finance.
I saw these odds on a betting site following Manchester United’s victory in the two-leg tie against Barcelona. The bet would be for the Reds to win all four of the competitions they are still involved in. United remain the only team to have completed the treble of the Premier League, the FA Cup, and the Champions League in the same season. This would be different but all three English domestic cups and the Europa League would be an amazing feat. 500-1 probably reflects the unlikelihood of it happening but it is tempting. Roll on Sunday at Wembley - for the first test of whether it is realistic.