Investment Commentary Quarter 4 2021
Granite Coast Ltd - Cambridge Financial Planners
In economic terms, the developed world has shifted since the start of 2021. We began the year with vaccine rollouts in their infancy and here in the UK the need for a significant lockdown. As confidence and freedom have increased through the year so have economies. The graph below shows that China and the US had larger economies at the beginning of June 2021 than before Covid-19. An economy that is larger than before Covid-19 is above 0% and a smaller economy is below 0% in the following graph. Recovery will hopefully soon be complete. The next step is finding sustainable growth.
Economic GDP (Gross Domestic Product)
Source: Trading Economics
Vaccinations are a key component of recovery. Countries that have been able to rollout vaccines have been able to get back to a level of normality. Countries that have not been able to achieve sufficient vaccinations levels within their populations have been particularly vulnerable to the Delta variant. Several countries, such as India, Vietnam, Indonesia, Thailand and Australia, that managed Covid-19 well earlier in 2021 have fared less well in recent times.
Lockdowns have taken their toll on business production and the supply chain. This has resulted in shortages. Where there are shortages in key products used in the production of other items, the impact can be wide reaching. The shortages of microchips and semi-conductors are a prime example where demand is outstripping supply. There are only a few suppliers of quality chips and supply cannot easily be increased. This has impacted car manufacturing and many other electrical goods. A new car contains between 500 and 1,500 chips and in North America it is estimated that 1 million cars have been delayed due to supply issues. A secondary impact is demand for existing cars. Used car prices to the end of July 2021 were 41% higher in the US than the year before.
Shortages affect price and this creates inflation, this is evident in recent inflation numbers.
Source: Trading Economics
The big question is; will the inflation that is happening right now be temporary or will it persist? Our opinion is that it is a bit of both. It may take a couple of years for supply shortages and logistics issues to be resolved, but expectations are that they will eventually find stability and not be permanently in deficit. To continue with the example of used car sales in the US, sales prices experiencing highs now will reduce as new cars come back to the market.
Having said that inflation will be in flux, it does look like inflation will be higher in the 2020’s than it was in the 2010’s and there are a number of reasons for this:
- The ‘just-in-time’ logistics model is efficient, but is vulnerable to disruption. It is likely that businesses and consumers will learn from this and operate with more contingency. Contingency has a cost associated and may mean product or service costs are higher.
- The independence of central banks has become political. Governments through Covid-19 have significantly increased their control of bank money supply and lending. Politicians operate with mandates other than just economic ones and this may mean allowing higher inflation than if banks were independent.
- The globalisation trend appears to be unwinding. Having goods manufactured cheaply in China reduced annual inflation by 1% to 1.5% per annum in the 2010’s. This effect has now come to an end with China having paid higher wages as it has developed and a currency that was once weak has gained strength. This has reduced the ability to continuously reduce prices.
- Finally, a shock can change people’s perception of inflation. We can become used to inflation and therefore become accustomed to prices rising, allowing inflation to continue in the system.
After years of concern regarding deflation and how destructive it is to an economy a little inflation may be helpful.
United States – What happens next?
As demonstrated in the graphs earlier in this commentary, the US economy has recovered substantially, with the exception of employment. The size of the economy is now larger than at the start of Covid-19. Investment sentiment and confidence are strong which has been demonstrated by stock market performance. Notwithstanding, there are still numerous Covid-19 cases in the country and there is significant potential for things to go wrong.
The graph below not only shows a complete recovery, but a recovery of an upward trend. It is possible to draw a straight line through performance. It should not be assumed that performance will continue in the same way over the next five years.
S&P500 (Standard and Poor’s 500) Performance Over 5 Years
Source: FE Analytics
The lack of production and service capacity in the economy is part of the reason for the significant increase in US inflation, which was up to 5.4% as at 31st July 2021. There is also more stimulus to come from President Biden’s infrastructure plans. Although it will take time to be passed through negotiations with the Republican party, it will increase demand on key commodities and employment when passed. Investment professionals can see these signs and are therefore repeatedly asking the question:
‘When will the Federal Reserve need to increase interest rates and slow down the economy?’
The Federal Reserve is conscious that investors are very sensitive to interest rate rises, we therefore expect any increases to be flagged to the market. As an example, the Fed have used this path with announcing the reduction Quantitative Easing (QE). They informed the market of the intention to reduce QE through a speech from their chairman Jerome Powell at the Jackson Hole Symposium at the end of August. This was followed at the Federal Reserve meeting on the 22nd September where it was intimated there will be an announcement at the next meeting in November. Markets took the soft announcement in their stride.
UK – Growing pains
As shown in the first chart, the UK economy has reopened after Covid-19 and created a huge economic recovery as a result. For the 12 months to the end of June 2021, the UK economy is 22.2% larger than a year ago. This is the largest increase in the developed world. It is in part due to the UK struggles in 2020 and the timing of lockdowns, but it is a significant recovery nonetheless. As well as the global trade disruption suffered by the rest of the world there is an additional factor for the UK economy; the UK leaving the EU.
The rapid growth of the economy has resulted in growing pains. The UK is short of lorry drivers and McDonald’s stopped selling milkshakes which are both part of a supply chain bottleneck. Some factors are short-term, such as the ‘pingdemic’ of workers forced to self-isolate coincided with the school holidays leading to unusually high absences. A longer term impact is immigration. The Office for National Statistics estimated 364,000 fewer EU nationals are working in the UK in July 2021 than there were in July 2020. In a rapidly expanding economy a significant reduction in labour is going to exacerbate supply shortages. These factors may mean shortages persist in the UK longer than other parts of the world.
Europe – Catching up
After a slow start to vaccination in Europe and then some resistance from the general public, vaccination rates and government is working hard to increase uptake.
The European Central Bank (ECB) as a whole has been more cautious about preparing markets for a return to normal policy than the US Federal Reserve and the Bank of England . While the eurozone economy is rebounding faster than expected, the ECB has also highlighted the risks to the expansion. There is the uncertainty posed by the spread of the Delta variant of the coronavirus, which could further slow consumer spending. There is also the risk that supply chain disruptions could last longer than expected resulting in wage increases and other price pressures. This would undermine the belief that most of the short-term increase in inflation will be temporary, yet, at the same time the ECB seems less concerned about inflation than it has been during recent times. It is unusual for the ECB to be bolder than other markets and is an interesting development.
Japan – Significant change
Suga Yoshihide, Japan’s Prime Minister, has declared he will not stand for re-election in November. Mr Suga’s resignation means his reign lasted one year almost to the day. He took over from Abe Shinzo who, after eight years as Prime Minister, resigned due to ill health. Suga’s resignation may herald a return to the previous era of weak Japanese politics, where divided governments are unable to enact policy changes. Prior to Abe, Japan had six Prime Ministers in six years. This may be beneficial as it will allow the key reforms of Abe’s reign to continue without interference, providing a stable environment for investment.
Asia – Chinese reforms
The Chinese government has announced a number of reforms in the last few months that have had financial implications.
These measures are not unreasonable, but they have surprised investors and demonstrate that the Chinese state is willing to exert increasing amounts of control over private enterprise. It is reasonable to assume that further measures will come through where China wishes to manage its economy.
The theme of recovery has been very strong in 2021 as the developed world is emerging from Covid-19, whilst ongoing cases continue. Government stimulus over the last 18 months has made a difference. This has done very well in supporting the market, but it also distorted employment markets and investment decisions. In the UK we are yet to fully feel the withdrawal pains as stimulus ends. Over the next few years we are likely to see a divergence in economic activity and investment performance. There will be winners and losers in investment sectors and geographical regions.
“Difficulties mastered are opportunities won” – Winston Churchill
(Sources – Financial Express, Office for National Statistics, Trading Economics, The Economist, Financial Times, BBC News, Reuters, Washington Post)
Views and opinions expressed are presented for informational purposes only and are a reflection of Granite Coast’s best judgment at the time this commentary or other content was compiled.
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