Jonathan Marriott, Chief Investment Officer
Government bond prices have sold off over the last quarter and expectations for inflation and interest rate rises have grown. While some of these drivers are the same, there are also significant differences. With the roll-out of the vaccine in the US and UK much faster compared with elsewhere, it seems likely that they will be the first countries to recover from the pandemic. However, when looking at interest rates and inflation, there are additional factors to consider.
What central banks are saying
This week, Federal Reserve (Fed) Chairman, Jay Powell, reiterated their view that a rise in inflation this year would be temporary. He continued his dovish tone saying that, while parts of the US economy are doing well, unemployment remains high. As the vaccination programme progresses rapidly, the economic outlook looks brighter. The majority of Fed members do not expect to raise rates until beyond 2023.
Despite this, the market has moved to price in higher long-term inflation and a rate rise before the end of next year. Monetary policy is just one side of the stimulus applied to the US economy; the other side is fiscal stimulus provided by the Biden Government. They have already passed a $1.9 trillion package and now plan a further $2.25 trillion. This latest package should be funded by corporate tax rises, but with only the narrowest of majorities in the Senate this will be hard to pass in full, so the whole package may be scaled back. However, we can be sure that fiscal and monetary stimuli are likely to remain substantial in the coming months.
In the UK, the Bank of England has also expressed the view that any rise in inflation will be temporary. Although the furlough scheme prevented a steep rise in unemployment, it may disguise the scale of the problem. Chancellor Rishi Sunak is looking to balance the books and is also raising corporate taxes, but with a delay. President Biden's move for a global minimum corporate tax rate may be difficult to agree. The Irish economy for example has benefitted from a low tax rate and they would try and block any move by the EU to agree a higher minimum rate.
Drivers of inflation
Annual inflation in the US will rise over the next couple of months, largely because of the base effects last year. In April 2020, the oil price dipped sharply as the economy shut down and there was excess supply. West Texas oil futures went temporarily negative, even Brent crude was at $20 a barrel (today it is over $60). In the US, this has a big impact on petrol pump prices, which have risen over 40% from the low of last year. UK petrol prices have not been impacted in the same way, partly because the price has a much higher tax component and also the pound has risen by over 10% against the dollar. Here in the UK, the average pump price is only up 10% over the same period.
A recovery in the sectors worst hit by COVID-19 may see price rises for travel and leisure. Disruptions in supply chains have led to shortages that mean input prices are rising. There is also a global shortage of computer chips, hampering production. All these effects may be temporary. Concerns over supply chains may make a move away from globalisation to local suppliers a priority that could push prices up in the long run. The other inflationary concern is an overhang of excess stimuli both monetary and fiscal.
Prior to the pandemic, there were deflationary pressures – many of which will remain in place after the pandemic. In Europe and Japan, we have had near-zero interest rates for many years, without seeing any inflation. In the US, pre-pandemic record low unemployment was not inflationary; with many jobs lost permanently, it will take time to achieve full employment again. Globalisation has kept costs down and, while there are concerns about supply chains, this will remain a deflationary influence. Internet price comparisons make it hard to raise prices. Automation and artificial intelligence will also reduce the need for expensive labour so, even where production is localised, it may not raise costs. Furthermore, ageing populations will generally be deflationary, although the cost of care in old age may rise.
Although most of these factors impact the US and UK similarly, the UK also has Brexit to contend with. The cost of trade and delays at ports is hard to measure at the moment, because the pandemic effect is so much greater. Given the vaccination rate, the UK economy should recover faster than Europe, but trade difficulties may then hamper the recovery. With short-term travel restrictions, the domestic leisure sector may get an additional staycation boost this year. However, it is in everyone's interest to improve the flow of goods between the UK and Europe. When European tourism reopens, these factors may be short-lived. So, while the oil price has less of an impact on UK inflation, there are other factors that may temporarily boost inflation in the UK.
The rise in inflation this year should come as no surprise for the markets and therefore may have little impact unless it is excessive and seen as prolonged. On balance, we agree with the Bank of England and the Fed, expecting the rise in inflation to be transitory. We expect interest rates to remain low which will continue to support equity markets. It also justifies some fixed income exposure, particularly US Treasuries, in balanced portfolios.
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