October 2021 Insights

Things Are Getting Better But This Is Still No Time for Complacency

On the surface, the UK economy is improving, especially considering where we were at this time last year, when the country had barely emerged from its first lockdown before plunging into its second one. Business activity has recovered rapidly from last year’s trough, with most sectors witnessing expansion. As the economy recovers, the job market is also perking up. Job vacancies soared to a record high in mid-August. Average growth in wages rose 7.6% on an annual basis and unemployment fell to 4.7% in the three months to June.

Much the same is happening, to a lesser or greater extent, across North America and other parts of Europe. Struggling economies are getting back on their feet, some more groggily than others. But all of them are suffering the lingering effects – what you could call the “hangover” – of multiple lockdowns. In many European countries the price of natural gas – a key source of our energy needs – has surged four or five-fold in recent months. That in turn is fuelling higher inflation. The UK has also been hit by shortages of petrol, food and other essential goods.

These stark developments should serve as a reminder that we are still in very much unchartered territory. Even as economies get moving again and the global economy returns to growth, this is still no time for complacency.

Good Data, At Last

Most advanced economies saw robust growth in the second quarter. The UK economy recorded year-on-year growth of 4.8%. That’s a big increase albeit off the extremely low levels from the second quarter of 2020. The US economy grew at a seasonally-adjusted annualized rate of 6.5%. Japan expanded 7.5% year on year whilst China posted 12.7% growth for the first half of the year.

Even the euro-area economy business activity roared back to life in July, expanding at its fastest pace in 15 years, as the lifting of travel restrictions injected life into the bloc’s dominant service industry. In the UK, the seasonally adjusted IHS Markit/CIPS Services Purchasing Managers’ Index (PMI), which tracks how executives of unnamed companies perceive various aspects of business at their own company, clocked in at 59.6 in July. It was the weakest rise in business activity since March but it was still well above 50, the no-growth line.

This abundance of encouraging economic data should hardly come as a surprise. Never before in history have so many governments, central banks and international financial institutions done so much to boost short-term economic growth and financial market performance. In the UK the FTSE 100 is within 300 points of reclaiming the level it was at just before the pandemic. Germany’s benchmark index, the DAX 30, already pulled off that feat more than six months ago. So, too, has France’s CAC 40.

As for the S&P 500, it is still close to a historic high, even after the recent correction. In August it officially doubled from its March 2020 low. Normally it takes the market years to double from previous lows. This time it took just 17 months. Of course, this has less to do with the “economic recovery” than the $120 billion a month of liquidity the Fed is pouring into the financial sector. Since January 2020 the US Money Supply has increased by a staggering 32% and has already set a new record for the largest ever 2-year increase.

But it has come at a cost: government deficits and debt and central bank balance sheets are through the roof. In the US alone the government has borrowed $5 trillion for its stimulus programs and the Federal Reserve has printed $4 trillion of new money. But if the ultimate goal is to regenerate the economy after last year’s crisis – albeit temporarily and at huge cost – while warding off the mother of all credit crunches, it appears to have worked – at least up to now. The question is what happens next?

Some analysts and investors of a bullish bent believe we could be about to witness a golden era of economic growth as we transition from industrial-based economies to digital-based ones fuelled largely by renewable energy. In his recent opus, The Rise of America: Remaking the World Order, Marin Katusa argues that opportunities will abound during this grand transition. At least some of the ungodly amounts of money being printed by central banks and borrowed by governments will end up financing the creation of a new economic model embracing the latest achievements in industries like biotechnology, robotics, and energy production. According to Katusa, the country at the leading edge of this transformation will be the USA. ¹

Focusing on the short-term, there’s comfort to be found in all the liquidity sloshing around the economy. With the global M2 money supply at record highs, having grown by over 20% in the last year, and with household savings close to an all-time high in the UK, there is still plenty of room for more spending. As long as economic conditions continue to improve and consumers’ fears of pending doom subside, people will begin to dip into the savings they accumulated during the lockdowns.

To an extent, this is already happening. Consumer spending was a vital motor of growth in the second quarter, adding 4.1 percentage points to the 4.8% increase in GDP.

No Time for Complacency

In sum, things are looking up, at least according to much of the economic data. However, this is still no time for complacency. As far as the pandemic is concerned, we are not out of the woods by any means. The global economy is still extremely fragile, as the recent downfall of Chinese real estate behemoth Evergrande amply demonstrated. There are other threats amassing on the horizon. Here’s a summary of what we believe are the five most important ones:


1) The Delta effect.

Much of Europe and the US saw a big wave of infections resulting from the explosion of the Delta variant. The good news is that the number of resulting deaths was down, in some places significantly, on previous waves. The bad news is that there are growing signs of waning vaccine efficacy. The fact this is all happening at the height of summer, when conditions are least favorable for viral contagion, is particularly concerning.

It is also bad news for the economy. After all, the entire economic recovery narrative was predicated on the premise that the vaccines would bring the virus under control, allowing economies to breathe again, reopen and begin the long, arduous process of recovery. If, instead of that, economies begin to shut down again, as has already happened across Asia and Oceania, confidence can quickly crumble, giving way to uncertainty.

Another round of lockdowns could result not only in more economic instability but also social and political upheaval in some countries. As happened in February last year, when it finally dawned on investors that Western economies were not immune from Covid-19, the result could be a swift, sharp correction in the financial markets.


2) Debt market strains are beginning to show.

Never before, not even in wartime, has so much new money been conjured into existence in such a short space of time. More millionaires have been created during the pandemic than ever before. Government deficits all over the world, including in the UK, have soared to record peacetime levels. This has fuelled concerns that many economies are now wholly dependent on exponentially rising fiscal and monetary stimulus.

This was arguably already the case before the pandemic but has since got a lot worse. The House of Lords released a report in July warning that the Bank of England risks becoming addicted to creating money and needs to explain how it plans to unwind its £895bn bond-buying programme. The concerns raised in the report specifically relate to the Bank of England but they could equally apply to just about every large central bank on the planet.

Those central banks now have a lot less room for maneuver. One of the big problems with quantitative easing is that it gets more and more ineffective and difficult to sustain the longer it goes on. Yet although there is increasing chatter about the US Federal Reserve planning to taper its QE program, the reality is that reversing course at this late stage in proceedings is going to be extremely tricky. The last time the Fed tried to trim back its stimulus, in 2018, it caused a 17% correction in the S&P 500 – the so-called “Taper Tantrum”.

In China, meanwhile, local governments are scrambling to launch rescue funds worth billions of dollars to bail out state-owned groups after a flurry of defaults. The latest recipient was China Huarong Asset Management, which in August was given a $16 billion rescue package. But government support has only been forthcoming for large financial institutions. Other struggling borrowers, including property developers, have to fend for themselves.


3) Worsening supply chain problems.

Global supply chains suffered two colossal shocks last year. In March they were hit by a supply shock as lockdowns and travel restrictions made it all but impossible to produce and distribute many products. Then, in November, as the global economy began picking up, they suffered a huge demand shock, as billions of consumers around the world began consuming once again. As is becoming increasingly apparent, there simply aren’t enough trucks, freight trains or ships in the world to transport all the bikes, semiconductors, car parts, computers, trainers, petrol and other things those consumers want to buy.

If anything, this problem is getting worse rather than better, and it is affecting all countries at the same time. Since the beginning of the pandemic, shipping prices have risen fivefold. This in turn has fuelled a surge in the prices of many raw materials and finished products.

The UK’s recent departure from the EU has merely compounded this problem. According to the CBI, retailers’ stock levels are now at their lowest point since 1983, due to worker shortages and transport disruption caused by the Covid-19 pandemic and Brexit. Andrew Sentance, a former member of the Bank of England’s monetary policy committee, said labor and material shortages were the most acute in decades and painted a grim picture for the British economy.

“It’s quite striking, I don’t think we can dismiss this as a flash in the pan,” he said. “Now that lockdown has been eased, we’re seeing a truer reflection of the impact of Brexit and issues building up before the pandemic.”

The latest manifestation of this crisis is the recent petrol shortage in the UK, which left many forecourt pumps dry. Much of the blame was placed on a shortage of lorry drivers, which in turn was (predictably) blamed on Brexit, and media and social media-fuelled (pun intended) panic-buying. Yet as The Economist notes, firms across Europe are encountering difficulties in finding and hiring workers to operate their ​​vans, lorries and tankers:

“Drivers are getting older, more are retiring, and younger ones are put off by difficult conditions. Without drivers, supply chains are getting stretched.” ²


4) Non-transitory inflation.

One thing that history teaches us is that supply chain shocks often fuel high inflation. When the French invaded and occupied Germany’s Ruhr Valley in 1922, as a result of Germany’s late payment of reparations, production came to a standstill. Within weeks prices were soaring. When the government responded by printing more and more money, the inevitable consequence was hyperinflation.

A similar pattern occurred in the 1970s. When oil-producing Arab countries expressed their dissatisfaction with the outcome of the Yom Kippur war (1973) by withholding petroleum, the price of a barrel of oil quadrupled in the short space of a few months. This was the initial spark for a decade of high inflation, but it wasn’t the only factor: accommodative central bank policy, the abandonment of the gold window, Keynesian economic policy, and market psychology also played their part.

As we warned in our last newsletter, rising inflation is a huge cause for concern. Supply chain shocks continue to multiply at the same time as governments and central banks, working almost in unison, borrow and print at unprecedented levels. In doing so, they have greatly inflated the prices for financial assets, including vital assets like real property and housing. They have also – almost by accident – inflated prices for basic goods and services.

There’s no way of knowing how long this period of inflation will last or how high prices can go, but one thing is clear: it’s certainly not as transitory as central banks were claiming just three or four months ago. Even some of those central banks, including the ECB and the Federal Reserve, have begun to acknowledge that inflation could be a little stickier than they had originally thought.


5) Record valuations across all asset classes are normally a sign that a correction is in order.

This is a basic truism that needs to be dusted off and reiterated every few years, especially when markets are hitting record highs. We have witnessed one of the sharpest economic recoveries in history. Spending on goods in the US is up 20.1%, according to Aneta Markowska of investment bank Jefferies. But this trend may already be running out of steam: Retail sales fell more than expected in July, as the boost to spending from the economy’s reopening and stimulus checks faded. Is this a blip or are US consumers already tapped out?

What should worry us most is that this is all happening in the “most over-stimulated economy ever”, says San Francisco-based market analyst Wolf Richter:

“Markets have gone nuts, prices are going nuts. This over-stimulation still continues, even as inflation pressures are bouncing through the economy, with price-spikes backing off here only to pop up there.

No one before has ever seen an artificially pumped up monster like this before. And no one has any historical guidelines on how to deal with it. The Fed will trim back its stimulus, but it’s already too late, and it will be too little and too slow.”

All of this leaves us in a tricky spot. Recent economic data and market trends suggest that things are getting better, especially compared to where we were a year ago. That should be cause for optimism. But there are also signs that the monetary and fiscal stimulus may be losing its effect while the risks of overloading on stimulus continue to grow. At the same time, the Delta wave has brought many economies to a standstill, including many in Asia which account for a huge chunk of global manufacturing activity. And that has heaped even further pressure on global supply chains.

In the northern hemisphere, autumn is just round the corner. Will we see more waves of infection? More vaccine-evading variants? Will flu make a comeback? Or is the worst of this crisis finally behind us? For now it’s impossible to know, which is why this is no time for complacency.


¹ The Rise of America Katusa Research Publishing 2021
² www.economist.com/graphic-detail/2021/09/30/all-of-europe-is-desperate-for-more-lorry-drivers