It is a long held contention of Bob Semple, one of our resident Wise Men who provide us with economic and market insight over the course of the year, that the economic recovery from the depths of the downturn in 2009/10 is unique in UK post war history because of the relatively consistent rate of quarter on quarter growth experienced over that time. Specifically, there have been no “gangbusters” periods of growth where a spike in activity is experienced over two or three quarters. Past cycles have typically delivered something of this nature. There are multiple reasons why this might be the case: the extended period of household, bank and government deleveraging; the impact of excess capacity globally weighing on prices and therefore returns; continual risk of political instability across the developed world; or simply that there has not been a period where enough of the global economy has fired at the same time to generate sufficient upward momentum. Whilst this is not an exhaustive list of the reasons behind the last decade of slow growth, it covers a lot of it. And, with the exception of political instability, there are reasons to believe that some of these effects are finally waning.
Much of the recent equity market commentary has focused on justifying recent increases in equity valuations relative to the impact that a stimulatory fiscal policy from the new Trump administration will have on economic activity, and with the potential for other governments to follow suit. Whilst this prima facie evidence that government retrenchment has come to end certainly helps the case for equities, it is only telling part of the story. Indeed, in all but the still dysfunctional banking systems of Italy and Greece, credit availability is generally growing, and in the UK the mortgage market is incredibly competitive at present. Which has, in turn, reversed the process of household deleveraging. In the UK and US, we know that households had been accessing more credit since 2013 – our European cousins have been following suit for almost the last two years.
A number of other factors other than re-leveraging are also at play, not least of which is that economic momentum is increasingly broadly spread across the globe. Commodity price rises have presaged increasing activity that is being recorded in secondary Chinese data like rail freight volumes. This at a time when US employment growth has picked up again and housing activity data have continued their (admittedly volatile) upward trend. Even in Europe, most countries are seeing meaningful reductions in unemployment levels, supporting an element of consumption growth. Economic growth is certainly tepid relative to what we came to expect in the latter half of the 20th Century, but at least it is more widely dispersed.
Perhaps the most dramatic shift in policy drivers in recent months has been the sharp uptick in inflation expectations. As a dweller in this sceptred isle, there is a risk that we only see inflation through a Brexit lens. That it is a function only of a devalued currency and a reliance on imports. That would miss the fact that inflation expectations are rising almost everywhere. The last time we had a decent bout of inflation, economies and labour markets had ample spare capacity. Policy makers could look through short term price increases and keep interest rates low. Today, labour markets are sufficiently tight that these expectations could creep into wage settlements, and become entrenched in future price negotiations. Indeed, a recent analysis by the Atlanta Fed charting the relationship between job openings and real wage growth in the US suggests that real wages are set to rise across the pond for the next year or so simply as a result past increases in job vacancies.
Moderate price inflation is beneficial to economies – and particularly net borrowers as it erodes the real value of nominal debt balances. It also helps companies maintain profit margins as there is less push back from customers on price increases, and can stimulate business capital investment by giving management teams an incentive to invest in labour saving technology and equipment. The challenge for policy makers and investors alike is to watch for signs that the inflation party isn’t getting out of control.
Perhaps this is running too far ahead of where we are today. Medium and long term bonds are certainly not pricing in any kind of return to wage fuelled inflation. Yet equities are pricing in more than some tax cuts and the building of a big wall in Texas.
As ever, though, there is always a reason to look over your shoulder. And it would be extremely naive to pretend that political mayhem can’t take us back to a more sobering reality. Domestically, Brexit and IndyRef2 (or “the Neverendum” as we might call it) are not going to be resolved soon. In Europe, we are counting down the weeks and months to find out just how anti-establishment the mood on the Continent is. In the US, the sight of a newly elected President railing against both the fourth estate and his own intelligence services can only increase the chances of the administration descending into chaos. (Perhaps it will happen in Sweden!).
All of this is being set against a backdrop where, as Kraft-Heinz have again shown, corporate buyers believe that there is long term value in UK equities. We have said in the past that we do not believe that heightened corporate activity is an infallible indicator of value in equities (anyone who worked through the dot.com boom can testify to that), but corporate buyers invest with longer time horizons than financial buyers and are closer to the reality of what is happening on the ground in their markets.
So, if there is value in UK equities, and the economic stars are potentially aligning, there may be a lot more to this mini bull phase of the market than relying on the dubious promises of a capricious politician.