It’s been a nervous time in booming equity markets, and bond markets too. As we get closer to the end of the year, a growing number of voices are drawing attention to several lurking risks that while so far have not held back markets, cannot be ignored.
There is the risk of a hard or badly prepared Brexit because of delayed and protracted exit negotiations. The looming constitutional crisis in Spain over the Catalan separatists’ movement has brought further risks to the European Union (EU). Globally, the prospect of a rising US dollar, and a slowing economy in China, could cause damage to emerging market economies. Geopolitical risks, such as the tensions arising from North Korea’s desire to be recognised as a nuclear power, are even harder to weigh up.
In the UK, pessimism levels have increased following a survey from the Confederation of British Industry (CBI) which revealed retail sales had fallen at the fastest rate since the 2009 recession. Consumers have drastically cut back on purchases and rising inflation has weakened their spending power. This reinforces our suspicion the UK economy is unlikely to see any marked pick-up in activity in the near-term, despite GDP growth edging up to 0.4 per cent quarter-on-quarter in Q3 from 0.3 per cent in the previous two quarters.
So, is there any good news to be had? Well, the squeeze on UK consumers should progressively ease in 2018 due to inflation falling back markedly as the impact of sterling’s sharp fall drops out. There will also likely be a gradual pick-up in pay in both the private sector and the public sector due to an easing of the pay cap.
We may not be quite there yet, but at least the global economy is consistently improving and synchronised growth around the world tells a story of expansion, not decline. The forward-looking capital markets also tell us they expect conflicts to be resolved rather than ending in a proverbial car crash. Until we know for certain, during the winter months it will pay to remain vigilant and pragmatic, as there may be as many risks to the downside as there is potential for upside.
Moving targets on inflation?
The question that's been resurfacing time and again over recent weeks is whether central bank policymakers are suffering a crisis of confidence.
The theme appears to be that central bankers’ continuing adherence to economic models that may have worked in the past may be misplaced in the current environment.
There may be some merit to this line of questioning, but we don’t think the evidence pointing towards central banks having run out of policy options is accurate.
That said, one area in which critics of central banks may be right is the dynamic of inflation. After years of the threat of deflation undermining financial and economic normalisation, central banks have effectively been keeping their fingers crossed for a general and sustained return of normal inflation.
However, one of most conventional sources of inflation – the labour market – has recently not contributed any meaningful inflationary pressures, despite record levels of low unemployment in the US, UK and elsewhere.
The current monetary policy framework is, of course, centred on inflation (and in the US also full employment). With the US Federal Reserve having achieved all but full employment but still undershooting the 2 per cent inflation target, even Federal Reserve chair Janet Yellen, a known proponent of more traditional monetary teachings, admits that they may have called inflation wrong.
Markets may therefore be a little puzzled as to why the Fed is still minded to be raising interest rates in December. We suspect the answer lies in rising concerns over asset price inflation, rather than price inflation.
In light of decent growth and rising employment, asset price inflation and the disruptive asset bubbles this brings may be identified as the bigger current risk to economic stability. Since it is not just the Fed that is struggling with the inflation puzzle, but also the Bank of England, the European Central Bank and the Bank of Japan, we should expect rate rises and rising yields not just in the US but globally.
‘Back to front’ inflation dynamics
In the UK, workers may have become familiar with the recent pattern of low unemployment, a record number of people in work, businesses complaining about labour and skills shortages, but no wage rises. The average worker earns less today in real terms than they did in 2006, despite the economy being 4.4 per cent larger per capita.
Most recently, the Office for National Statistics (ONS) reported the UK continues to create new jobs at a healthy rate, but higher inflation continues to squeeze real wage growth. The headline rate of inflation, the consumer prices index, surged to a five-and a half year high of 3 per cent in September, driven by higher living costs.
At last month's Treasury select committee meeting, Bank of England Governor Mark Carney said inflation would likely rise over 3 per cent in the coming weeks, peaking late October or November. Economists predict inflation could hit around 3.2 per cent in November, before falling back. Carney was keen to stress higher inflation should not come as a surprise, as they “expected sterling to fall sharply” in the Bank’s assessment before last year's Brexit vote.
Under other circumstances, low unemployment and higher inflation should lead to tighter monetary policy through a rate rise. But, since this inflation is not driven by wage growth and there is a weakening trend in retail sales, this is not the type of inflation that becomes persistent.
There may not be the need to raise rates, as there is very little risk of the economy overheating. Some might think this poor economic perspective would keep the Bank from raising interest rates today. However, given its numerous communications for a rate rise this year, this could cause credibility concerns that would once again be to the detriment of the value of sterling. A rate rise would also be supportive for the currency, and may therefore be more suitable to bring down price inflation and ‘stop the rot’ than doing nothing.