What's over the Economic Horizon?

By FMB on 

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Brexit uncertainty has been holding the UK economy back, but the UK has a good track record with some excellent companies. The city always thought a trade deal would happen as it was in the UK and EU’s best interests. UK underperformance was ending but the lockdown last year had an immediate and deep effect on the UK FTSE 100, due to the prevalence of mining, oil and banking companies listed. However, those sectors are bouncing back and the long-term prognosis is good.

With global growth greater than 5% most economies are in recovery so we can expect some inflation. The big question is how much?

According to Keynesian theory of countercyclical economics, when the economy and private sector is strong, government spending should be lower in order to avoid overheating. When the economy is struggling the government can invest in infrastructure to support it.

So far, we have borrowed 3 to 400 billion pounds, the national debt is currently 100% of GDP. Luckily the cost of borrowing is low (currently 0.8%) and the UK is easily able to service this debt at 1% of national income. We are now in a strong recovery, but still have high government spending which in Keynesian terms is procyclical and could lead to inflation. The US is currently spending trillions (albeit on much needed infrastructure), while their economy is riding high. This inflation risk has an impact across the global economy. Added to this, we still have quantitative easing which creates inflation too.

On the plus side, it does mean the UK and US are unlikely to follow Japan into stagflation and negative interest rates which dampens consumer spending. An aim of 1 to 2% inflation would be desirable. Consumers are happy with a tiny bit of inflation as wage inflation helps confidence and the feel-good factor. Can the central banks ride the tiger though and keep it under control?

Many fund managers are moving to protect their portfolios against inflation risk. It’s good for UK investors to have exposure to the UK economy as it builds in resilience to inflation on home turf, but investors also need to consider capital loss during a period of inflation. What worked well for the last 3 years might not work well for the next 3. The US market has a heavy weighting towards to tech stocks and valuations are incredibly high and with high earnings growth priced in. Time to take profits here.

Perhaps the current market position is a little over-confident about future lockdowns and complacent. Some of the risks still include:-

• The Virus, mutations and lockdowns
• Vaccine disappointment- future mutation
• Geopolitical instability
• Early withdrawal of stimulus
• Inflation and rising yields

The main problem to watch for is Biden’s policy of spending trillions when the US economy is strong and unemployment is low. Wages and pieces are starting to rise and government bonds may fall in value. There could be interest rate rises on the horizon. Any large rate rises will spook business.

Yields on UK financial assets have been decreasing since 2008 but be very wary of chasing returns that are too good to be true, for example 8% on aircraft leasing suddenly became 0% in 2020. High yield equals high risk. Digital currency is much talked about and there have been winners, but do you really want to invest in an asset when you don’t know who is backing it in an environment favoured by organised crime?

Commercial property is surprisingly buoyant in the honey spots, despite rumours of the death of the office. The need for warehousing has grown and actually more office space could be required to allow for social distancing.
Corporate bonds are another counter to inflation risk as well as commodities.

So, in summary a strong recovery, plus high government spending, plus QE is likely to lead to some inflation- the key question is how much? Royal London Asset Management agreed there are still risks for buoyant UK equities

“A resurgence of Covid-19 leading to a slip of the UK’s economic reopening timetable or, at the extreme, further lockdowns. The other issue that cannot be overlooked is the risk of rising inflation. If that occurs it may not hit the overall level of the market, but it would probably shift the mix of those sectors that perform well. A higher inflation world, where growth was easier to come by, might make some businesses that have been seen as having more inherent growth, less attractive. That would particularly be the case as many such businesses have seen their valuations driven to relatively high levels in the low inflation, low interest rate world of recent years.”

This does not constitute advice, FMB gives individual investment advice based on your individual circumstances and attitude to risk. If you would like to find out more about our investment process look here!

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