The curse of interesting times

 

We have started 2021 where we left off last year with Covid by far and away the most important factor shaping events but US politics continuing to dominate the headlines. It seems we say every year that the coming twelve months are the most uncertain we can recall, but this time it really is true. In my view, whilst the US political reverberations will eventually fade the scars of Covid will prove longer lasting.

 

The ongoing impact of Covid

 

Not only do we not know what impact the 2020 Covid-induced collapse will have on the economy this year but matters are being complicated by a big rise in infections at the start of 2021. Although a vaccine is now being rolled out, the fact that many European countries are tightening lockdown restrictions in the early weeks of the year means that we will see bigger output contractions than previously supposed. It will thus take longer for many economies to get back on their feet and we are unlikely to see a significant turning of the economic tide before the spring.

Growth forecasts made at the end of last year are likely to be significantly revised down in the course of January. If the vaccine rollout proves to be successful, we can expect a strong recovery in the second half of the year. But if it does not go as planned (perhaps because the virus mutates faster than the vaccine can keep up or distribution proves to be slower) any recovery is likely to be muted. Indeed I can well foresee a situation where a significant recovery in UK GDP growth is postponed until 2022 and it is hard to see any circumstances in which output in the larger European economies will get back to pre-recession levels in the course of this year.

From a market perspective, the dominant theme will once again be the hunt for yield. Central banks have pumped huge amounts of liquidity into the global financial system and will continue to do so in 2021. As a result downward pressure on bond yields will remain in place, forcing investors into riskier assets such as equities. That said, concerns that Joe Biden’s economic plans will result in higher government spending and higher inflation might put a floor under bond yields. Whilst I have lost count of the number of times I have indicated that equities look expensive when measured on the basis of conventional metrics, I have also pointed out on numerous occasions that measures such as the P/E ratio are not especially informative when interest rates are so low. I will thus repeat my prediction from last year that in the absence of an unexpected shock, investors can be expected to continue buying equities.

The politics will remain interesting

There is a lot to look forward to on the political front. Although the Washington unrest is a big deal and will echo throughout the generations to come, its impact on the economy is likely to be limited. We can expect a less rumbustious tone from the White House as Joe Biden settles in as US President although today’s storming of the Capitol in Washington reminds us that the fault lines running through US politics will not easily be healed. Biden is likely to adopt a more conciliatory tone towards his European allies, thus reducing some of the strains in the western alliance which have been a feature of the last four years. Moreover, the Democrats have won control of the Senate following the run-off in Georgia after the indeterminate result in November. As a result, the Senate is split 50-50 which will allow Vice President Kamala Harris a casting vote. This in turn will allow the President a much better chance of pushing through some of his domestic legislative agenda since initiatives in areas such as healthcare, the environment and government reform are less likely to be blocked.

This does not necessarily mean that Biden will be able to push through his more ambitious programmes such as the Green New Deal but at least some of the Congressional logjam will ease. This may not be altogether good news for markets which liked the idea of a Democratic President but a Republican-controlled Senate as a check on some of Biden’s harder-to-swallow ideas, but it is unlikely to cause more than a temporary market wobble.

Here in Europe, Angela Merkel is not expected to contest the German election in the autumn after her decision two years ago to stand down as Chancellor. This would be a real game-changer not only for Germany but also for the EU. At home, Germany’s handling of the first wave of the pandemic was reflected in a significant surge in the opinion polls for the CDU and even though the polls have softened a little since the summer, its 35% share is still ten points higher than in March. Merkel has presided over a number of difficult issues during her 15 year tenure as Chancellor and is seen as the ultimate safe pair of hands. If she does depart the scene as expected, she will be a hard act to follow.

But Merkel will be particularly missed at the EU level. Since she took office in 2005 the character of the EU has changed immeasurably, following the scarring experience of the Greek debt crisis and the departure of the UK. One of the biggest future challenges faced by the EU is how to deal with the political difficulties posed by Poland and Hungary, which were newbie members when Merkel became Chancellor but are now running in a different direction to the rest of the EU. Merkel's trick has been her ability to smooth over those issues which pose challenges to the political integrity of the EU. Her successor will have their work cut out to deal with the politics so adeptly. Of course, there is still an outside chance that Merkel will change her mind and contest another election but I would not want to put money on it.

Not forgetting Brexit

And then there is Brexit to look forward to which from here on becomes an economic rather than political issue. The UK is now completely outside the orbit of the EU which will give us a chance to assess whether the much vaunted economic benefits will materialise this year. Things have not got off to a great start. Under new tax rules, which admittedly are not directly Brexit related, the UK now requires foreign mail-order sellers to register for UK VAT for any items sold to British customers. They are required to collect the tax on behalf of the government and pay the money to HM Revenue & Customs. A number of small businesses have decided that it is not worth the bother to continue shipping to the UK with Dutch Bike Bits arguing it was “ludicrous for one country” to insist on these conditions and it would, in future, “ship to every country in the world . . . except the UK”. There is also the small matter of this week’s collapse of share dealing in the City of London prompted by a large-scale shift in euro-denominated shares from London to exchanges such as Amsterdam and Paris. The sky may not have fallen in but these are indications of changed post-Brexit circumstances which we were promised would not happen. As the year unfolds, a number of unexpected consequences are likely to become manifest.

The year ahead will undoubtedly be a turbulent one. Maybe the departure of Trump from the political scene will allow some healing to take place in the US. But Covid is not about to disappear anytime soon and in so many ways, we are experiencing the curse of interesting times.