10 December 2021

Emerging threats or transient difficulties?

Surprisingly little has changed since last I shared my views on how the domestic economy is shaping up in a post-pandemic world.


We’ve had the United Nations Climate Change conference in Glasgow, which seemed to have little influence on investor sentiment, though it's still too early to determine what any longer-term implications might be. Inflation remains a worry, while Covid continues to resist attempts to be pushed to the sidelines of our concerns. And supply chain disruption looks like hindering the economic recovery that has restored the fortunes of major economies to close to, or even above, pre-pandemic levels.

Despite all these uncertainties – and the heightened geo-political tensions that a more aggressive Kremlin is generating - at the time of writing, shares have held up remarkably well, with our own FTSE 100 Index finally returning to the sort of levels not seen since the recession hit, even if we continue to lag the US. Markets are clearly viewing the destabilising threats that surround us as merely transitory, but are they wise to shrug aside these concerns? Some of the influences could be said to be self-cancelling in some measure, but it is worth trying to assess just what might happen as the world adjusts to a new normal, post-pandemic life.

The imbalances in both the supply of labour and the availability of goods and services is not just a domestic issue.

With hindsight it is, perhaps, hardly surprising that both the cost of living and the delivery of goods should have been so disrupted by the changes wrought by the Covid-19 crisis. The initial reaction to the pandemic was to shut down vast swathes of economic activity, leading to massive destocking and a shift in working patterns all around the world. As consumers regained their confidence, so demand rose rapidly against a background of supply shortages brought about as businesses had sought to protect themselves by running inventories down.

Meanwhile, with particular industries hit hard by government measures to control the spread of the virus, many of those employed in such sectors as hospitality and transport, worried over the prospects for employment in the future, sought employment elsewhere. The result has been imbalances in both the supply of labour and the availability of goods and services. And this is not just a domestic issue. All around the world these problems exist in some form or another.

Establishing a more balanced environment will take time to achieve and one of the consequences could well be further upward pressure on the cost of living. Already in America inflation has topped 6% - a level most would have considered unlikely even just a few months ago. This brings it to a three-decade high, but with energy and fuel driving the rise in prices, the expectation remains that the upward pressure will moderate. After all, if prices stabilise, then inflation will too.

The rise in prices seems set to continue here too, with forecasts of above 5% likely for next year. Again, utility bills and the cost of fuel will be leading this charge and both should moderate in due course. Determining how wage inflation might affect the picture is altogether more difficult. In those sectors of the economy where labour shortages are limiting our ability to progress satisfactorily, such as transport, we are already seeing some quite significant rises in pay packets, which in turn could well encourage other workers to adopt harder line approaches when seeking wage settlements.

Wage inflation is by far the most dangerous element in the rising cost of living mix. But the self-correcting mechanism that could come into play is simply that of falling demand as consumers, hemmed in by larger energy and fuel bills, start to ratchet back their spending plans. With our nation remaining heavily dependent on the health of the consumer, this could swiftly translate into declining demand and a shrinking economy, which should stifle excessive pay demands.

A big hike in the cost of borrowing could have devastating consequences.

So, on balance I remain in the transitory camp so far as inflation is concerned, even though I fear it will take longer for the cost of living to return to a more acceptable rate of increase than many expect. The good news is that this should limit the Bank of England’s desire to raise interest rates. A big hike in the cost of borrowing could have consequences that would be devastating, as a whole new generation of home owners could find the additional burden of higher mortgage costs, alongside their inflated utility bills, simply too much to bear.

If inflation is likely to moderate and supply-side shortages equally capable of resolving themselves in the medium term, then it is the other, less predictable risks we need to monitor. The fallout from Brexit remains a worry, with the Northern Ireland question still unresolved and containing the potential to scupper the entire EU/UK trade deal. And the less than democratic Russian and Chinese governments more assertive roles internationally add further uncertainty. Whoever said forecasting the future was easy?
 

Illustration by Isabelle Bamburg

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