Ear to the Ground

June 10 2022

This week could potentially best be described as a week of confirmation. The increase in the cost of living has, for a number of months, been expected to have a detrimental impact on economic growth and we have started to see than come through in economic forecasts. This week we saw the OECD give their latest economic predictions for the year ahead. Only three received an upgrade to their forecast, being Argentina, Turkey and Australia, with the rest seeing downgrades, with some significant ones at that. Still, however, they predict that the global economy will grow this year at 3.02%, down from the previous estimate of 4.46%.

Focussing specifically on the UK, they forecast that the economy will grow 3.64% this year, down from their previous forecast of 4.75%. Private consumption is expected to slow as the sharp increase in the cost of living is expected to eat into household disposable income. Public investment is also expected to slow, not by design but due to the supply side bottlenecks and constraints which we currently are seeing.

Before the outbreak of the conflict in the Ukraine the OECD had expected growth and inflation to return to some sort of normality as supply side constraints faded as the impact from the COVID-19 pandemic waned. The conflict, along with the zero COVID policy in China which has led to further lockdowns has, however, created new negative shocks. As a result, the OECD acknowledge that supply side pressures have actually intensified. They now project that consumer price inflation will remain elevated, averaging c. 5.5% in the major advanced economies through this year, 8.5% in the OECD as a whole, before receding in 2023. Levels of inflation however are not consistent across countries within the OECD.

Equity markets initially took the report in their stride, perhaps due to much of the report conclusion being expected. The last few trading sessions of the week have seen something of a sell off however, compounded by concerns of partial lockdowns potentially returning in Shanghai. Bond yields meanwhile have risen slightly, with the US 10 year Treasury yielding now back above 3%, with the UK gilt equivalent yielding 2.3%.

This week also saw the ECB meet to discuss interest rates. Whilst there was no move in rates this month they signalled their intention to increase in July. This is expected to be a 0.25% hike. They also believe that rates are likely to increase again in September, with the scale of the hike to be determined by the inflation outlook at that time. The ECB then forecast a gradual but sustained path of further increases could be required from September onwards as they look to normalise rates.

Coming back to inflation, the higher levels which we are currently seeing have undoubtedly been driven by supply side constraints. There are market commentators however who are keen to point out that there has not necessarily been outsized demand. Rather, demand has simply, in total, only been reverting back to pre-pandemic levels. Whilst there has evidently been an increase in spending on goods, this acceleration was seen through lockdown periods when spending on services, in the main, was not possible. Spending on goods is now slowing. Although services spending is increasing, it is yet to get back to pre-pandemic trend.

Other commentators meanwhile continue to focus on money supply dynamics as the key driver of inflation. During 2020 and into 2021 we saw a sharp rise in money supply, through monetary and fiscal support for the economy, with CPI, with a one year lag, moving in toe. Tightening of that supply however has been sharp and therefore, if the pattern were too remain true, we should perhaps expect to see CPI move lower in a similar fashion. There are of course other variables at play, such as tight labour markets and wage pressure, but a trend to watch all the same.

Inflation remains at the forefront of the minds of not only investors but also the general public. The reasons are there for all to see at present, and to quote Ronald Reagan, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”

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