Recent data shows that the rate of inflation is slowing across the developed world. Investors have taken heart – but is their optimism misplaced?
What’s been happening…
It’s always nice to get good news. In the past few weeks, we’ve seen both a dip in inflation in many major economies and a sustained rise in the equity markets. The two factors are easy to connect: slowing inflation leaves room for central banks to stop raising interest rates and, in time, even start to cut them. That would allow businesses to borrow for less, which should translate into higher earnings growth. And this optimistic view is being reflected in higher share prices.
The strong recent performance of equity markets shows that investors think inflation will fall faster than economic growth – the so-called ‘soft landing’. We think that the chances of this have certainly increased – largely because US inflation has been falling so fast. Headline inflation in the US was just 3% in June, down from 4.1% in May and 9.1% in June last year.
In the UK, headline inflation is likely to keep moving lower too, given the reduction in Ofgem’s cap on energy prices at the end of June and its impact on utility bills. This could reduce inflation by almost a full percentage point when July’s figures are published later this month.
… and what might happen next
Despite this, we shouldn’t get ahead of ourselves. Why? Well, although falling fuel prices and a lower price cap are driving headline inflation down, core inflation – which excludes food and energy prices – is still far too high. It has slowed slightly – from 7.1% in May to 6.9% in June – but it’s still far ahead of where the Bank of England needs it to be. So inflation isn’t yet back in its box.
How, then, could all this play out? Well, a soft landing is certainly a possibility. But we don’t see it as the most likely scenario, for a couple of reasons.
Chart 1: UK economy – growth scenario
Sources: WTW and FactSet. This is an illustration.
First off, we don’t know how far inflation will fall. At present, wage growth is still high in many countries. If it stays high, then so too might inflation. And if that happens, central banks will have to raise interest rates further, clamping down on economic growth so that labour supply and wages can rebalance. So that’s one alternative to a ‘soft landing’: persistent inflation, further monetary tightening (higher interest rates) and, ultimately, a recession.
Second, we’ve still to see the full impact of the monetary tightening that’s already occurred. Over the past year, central banks have raised interest rates by 4 to 5 percentage points. The effects of that are still feeding through the system.
Typically, there’s a lag of one to two years between a change in interest rates and its effect on the economy. And, crucially, that applies to both raises and cuts. So even if inflation has been contained, growth may still weaken faster than most investors expect – and if the 2024 rate cuts that many hope for do indeed transpire, they’ll take many months to take effect.
Chart 2: UK economy recessionary scenario
Sources: WTW and FactSet. This is an illustration.
How we see it – and how we’re placed...
So what’s most likely to happen? It’s always hard to predict the turn of the economic wheel. But we doubt that core inflation will fall far enough for central bankers to feel comfortable – unless it’s curtailed by significantly weaker growth. In this scenario, a recession may be possible in the next 12 months.
That might sound bleak. But we can offer some comfort. Unlike current equity markets, we haven’t gone all in on a soft landing. Instead, our globally diversified investments strategies, which are built for the long term with risks like recessions in mind, aim to get us through less palatable scenarios in good shape.
Investment View: Are public sector pay rises bad for the economy?
Andrew Bailey, the governor of the Bank of England (BoE), has told UK workers not to seek large pay rises. The BoE’s chief economist Huw Pill has said that people should accept they are less well off. But with tens of thousands of public sector workers striking and the government at odds with the unions despite a 6% pay offer, will meeting wage demands prove inflationary?
In May, weekly earnings growth was 5.8% in the public sector. But in the private sector, it was 7.1%. Some context helps here: the public sector is just 17.7% of the UK workforce. Meanwhile, the unions aren’t the dominant force they once were. Unionised workers make up only 22% of Britain’s workforce, and only 12% of private-sector workers are unionised.
So, if the UK has a problem with wage growth, it’s largely a problem of the private sector. And it’s highly unlikely to have been created by the unions. In fact, since the start of the Covid pandemic, wages in the public sector have lagged those in the private sector – and are down significantly in inflation-adjusted (real) terms.
Chart 3: Year on year real earnings growth (%) since 2000
Sources: atomos and FactSet
Why labour costs matter...
Of all the prices in the economy, the price of labour is special. It plays a part in many other prices because it’s an important input cost for most goods and – especially – services. And rising incomes increase demand and spending, which tends to put upward pressure on other prices. Why labour costs matter...
Think of it this way: if the price of a pint of milk goes up, it adds to inflation directly but not indirectly. But if dairy workers get a pay rise, it adds to inflation both directly and indirectly – because they’re likely to spend the extra income they’ve earned.
Currently, real incomes are declining. In other words, consumers are getting poorer because inflation is rising faster than wages. Even so, an increase in nominal wages means that more money is chasing the same amount of goods and services – helping to keep inflation above the BoE’s 2% target.
Pay vs profits
A bit of extra income and spending isn’t a problem in itself. But when inflation’s already too high, extra spending can make the problem worse. That’s why outsized pay awards are such a difficult issue in the UK – and why BoE officials are prepared to make themselves unpopular by saying so.
It's worth noting that corporate profit margins have a role to play here. Wages can rise without stoking inflation so long as companies don’t pass higher costs on to their customers. Andrew Bailey has talked about this too, saying “We can't have companies seeking to rebuild profit margins”. These comments, however, have attracted fewer headlines.
A balancing act
What, then, are the government’s options? Well, it doesn’t have many, and it has a delicate balance to strike.
On the one hand, pay demands from the public sector are reasonable: people are just trying to maintain their living standards. And the country needs these workers to be well motivated and fairly rewarded given the size of the challenges they face – the long waiting lists in the NHS, for example.
But on the other hand, if the government meets wage demands by borrowing more, it risks creating further inflation in two ways. First, it may incentivise more pay demands next year – creating a wage-price spiral in which wages go up because of higher prices and prices go up because of higher wages. And second, if pay rises are funded by extra borrowing, the government will be adding extra demand to an overheating economy.
What’s really needed is a little sleight of hand: increasing public sector wages just enough to motivate workers while shuffling the fiscal cards so that not too much more borrowing is required. But doing this in such a way that voters don’t think public services are suffering will be no easy task!
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.