Vladgrind

My initial thought twelve months ago following the Russian invasion of Ukraine was that the tectonic plates have shifted. Nothing that has happened in the interim has caused me to change my view. It soon became obvious that the war was going to be a more protracted affair than Vladimir Putin anticipated (or was told by his advisers) and slightly belatedly the west realised that it had a duty to provide physical support to show that its support for democracy amounted to more than just words. There has been a cost, both economically and geopolitically, and the issue over the next twelve months will be whether the international community is prepared to continue paying the price.

Polling evidence shows that Europeans and American citizens believe Ukraine should continue its fight to regain the territory occupied by Russia, although in other geopolitically important states there is less support for such a position (chart above). The continental European position is understandable. There is more concern than elsewhere that the war could spill over and draw them in to defend their territory or that of their neighbours. Quite how events will pan out over the next twelve months is difficult to say. The likelihood is that the war of attrition will continue, with Ukraine not having the resources to push Russian forces out of their territory but Russia unable to make significant territorial gains. Further ahead, the manpower differential makes it difficult to see how Ukraine can regain the territory it has lost without regime change in Moscow, suggesting that some form of negotiated settlement might be the best we can hope for.

The economy has so far avoided the worst case outcomes …

Undoubtedly the Ukrainian war has had a big impact on the global economy, following hard on the heels of the Covid pandemic. This has manifested in an inflation shock, the likes of which we have not seen in 40 years, and prompted central banks around the world to raise interest rates, having kept them at historical lows for far too long after the GFC. The slowdown in the global economy has been pronounced but perhaps less dramatic than anticipated towards the end of 2022, with euro area GDP eking out a small rise of 0.1% q/q in 2022Q4, thus ensuring that the economy continues to avoid recession. Germany is facing a tougher haul but even the 0.4% contraction recorded in Q4 was better than anticipated a few months ago.

Germany in particular has coped far better than anticipated in managing its gas storage. As of end-February, storage levels were at 71.7% of capacity (chart below) whilst gas consumption in the week beginning 13 February 2023 was 22.7% below the average for 2018 to 2021. As a consequence, Europe’s largest economy has avoided significant blackouts which has prevented sharper falls in output. But contrary to suggestions expressed in the media of late, we are far from out of the woods. Indeed, although it is likely that Germany – and indeed the rest of Europe – has sufficient gas on hand to get through to the autumn, much depends on how easily gas storage levels can be topped up ahead of the winter. In the event that Germany cannot easily top up supplies from non-Russian sources in 2023, we could go into next winter with perilously low supply levels which would be problematic if there is a cold winter.

… But …

A tightening of monetary policy has helped to curb demand but this all points to the fact that rather than a winter 2023 recession, we could instead face a similar outcome in twelve months’ time. For this reason, markets are looking nervously at the actions of central banks as they continue to tighten monetary policy in the face of a rising inflation threat. But it is not headline inflation they care about so much as the pickup in core inflation as prices respond to the big rise in energy costs that occurred in 2022. On top of this central banks also care about the prospect of a response from wage inflation which could set off a wage-price spiral. So they keep nudging rates higher. And the higher they go, the more likely the prospect that the economy finally tips into recession – not as a direct result of higher energy costs but as a result of tighter monetary policy.

That might seem a remote prospect in the US today but the operation of monetary policy involves lags which are often not known with any precision. As interest rates in the US rise and inflation falls, so the real interest rate – which is assumed to be a key factor in driving real activity rates – becomes less negative. Based on latest data, for example, the real Fed funds rate climbed from a low of -8.2% in March 2022 to -1.8% by January 2023. Admittedly this is still in negative territory but add 25bps to the funds rate and assume inflation comes down by another 1.5 percentage points to 4.8% and the real rate is back at zero. The further inflation falls as the energy price shock drops out of the calculations, the greater the upward pressure on real rates and the bigger the drag on the US economy – and by definition the rest of the world.

Back to where we started

Putin calculated that NATO’s European members, which were heavily dependent on Russian gas, would scale back their opposition to the invasion as the restriction of gas supplies put intolerable pressure on the European economy. So far this calculation has not worked out. European opposition may yet soften if the economy falls into recession, either as a result of domestic policy errors or those of the Federal Reserve. However, rather than a short, sharp recession, it is far more likely that the European economy will experience a longer period of little to no growth, which will raise the pressure on policymakers in different ways. Coupled with high budget deficits, which may prompt some form of fiscal consolidation, the near-term outlook for the European economy is not a pretty one. The polling data suggests that European governments can afford to stay the course in 2023. Whether they will be prepared to do so further ahead as elections loom may be another matter.

Reflections in a time of Covid

A year on

Last Thursday marked the first anniversary of the World Health Organisation's classification of the Covid-19 outbreak as a pandemic. The lives of millions of people have since been put on hold as governments have been forced to lock down their economies in a bid to halt the spread of the disease. There have recently been some signs of improvement with the mortality rate across Europe significantly below its January peak as a result of renewed lockdown conditions and the acceleration of the vaccine rollout. However, daily case numbers are rising again in a number of continental European countries. They have almost doubled in Italy in the past three weeks, prompting the government to tighten restrictions, whilst in Germany the Robert Koch Institute for infectious diseases predicted that the number of daily reported cases could exceed the December peak by mid-April. The rate of decline in UK cases, which has been proceeding rapidly for the past two months, has recently slowed although there is insufficient evidence to know whether this marks a turnaround or is just a blip.

We have learned a lot about pandemics and how to manage them over the past year. The most important lesson is that lockdowns do work and in this regard the UK was slow off the mark in spring 2020. It is sobering to recollect that health experts were aware of the scale of the problem ahead of us. This edition of Question Time, the BBC’s weekly topical debate programme, from 12 March 2020 featured Professor John Ashton who delivered a withering critique of government policy and accurately predicted what was about to unfold. His efforts to highlight the extent of the disaster stood in stark contrast to the complacency of government ministers at the time. The fact that more than 125,000 people in Britain have died from Covid over the last year – the fifth highest total in the world – is testimony to policy failings. When normalised to account for the size of population, the UK’s mortality rate of 188 per 100,000 is the highest of any country with a population over 12 million (chart 1).

The more positive news is that the vaccination rollout appears to be a great success. Although Israel is well out front in terms of vaccinations delivered, the UK and US are gaining momentum (chart 2). It is sobering to recall that a year ago we were warned that it could take years for an effective vaccine to be developed. At that time the fastest any vaccine had previously been developed, from viral sampling to approval, was four years – for mumps in the 1960s. The vaccination process has not been without its controversies: Concerns persist about the effectiveness of the AstraZeneca vaccine with the most recent issues surrounding its potential side effects. In addition, there is a vaccine hoarding problem with the developed nations having bought a large supply of the world’s available stock, thereby leaving less for the poorer nations. Nonetheless, it is remarkable that such huge strides have been made in the space of just 12 months.

But we are not yet out of the woods. Lockdowns in some form or another are likely to remain in place well into April, which effectively means that economies in most parts of Europe will be operating under highly restricted conditions for up to one-third of the year. So long as concerns about new Covid variants remain a live issue, we cannot afford to be complacent with regard to the prospect of a further coronavirus wave.

Counting the economic cost

From an economic and market perspective it has been a wild ride. Last year saw the largest peacetime contractions in output in almost a century (more than 300 years in the UK case) and we cannot be confident about the pace of the rebound in 2021. In spring 2020 it was widely assumed that the contraction would be followed by a rapid recovery but a second wave of the pandemic has led to rather more muted hopes across Europe. That said, the OECD recently revised up its expectations for global growth in 2021 compared with last November with particularly rapid growth projected for China (7.8%) and the US (6.5%). Latest UK figures give some grounds for optimism, with GDP in January falling by only 2.9% versus expectations of something closer to 5%, and as a consequence it is likely that Q1 growth will turn out less bad than the 3.5% contraction currently pencilled in by the consensus (which will raise the annual growth rate, ceteris paribus).

The jury is still out as to the nature of the economic recovery. The economic shock has had implications for both the supply and demand side and the shape of the recovery will be determined by trends on both sides. Demand is likely to rebound fairly quickly, particularly given the extent of unanticipated household saving which is likely to be rapidly run down (chart 3). That said whilst spending on goods may pick up as the retail sector opens up, a lot of the spending on services which has not taken place over the last year will simply not be recouped. After all, we are unlikely to go on more holidays or make up for a year’s worth of foregone restaurant meals. It is for this reason that the damage to the supply side of the economy is hard to gauge. The future states of the airline and retail sectors are likely to be different to their pre-Covid form, whilst the leisure sector has taken a battering from which many establishments will find it difficult to recover. It is for this reason that I maintain the recovery may prove slower than a lot of projections currently suggest. 

Markets on edge

From a market perspective, in March 2020 we were about to step into the unknown – never in living memory had we experienced a global pandemic and equity markets quite simply collapsed in the face of unprecedented uncertainty. Following the actions of central banks to provide unlimited liquidity, the subsequent rebound took many by surprise – myself included. Indeed, we are now at the point where many investors believe the equity rally is overdone with the S&P500 closing last week at a record high – around 17% above the pre-pandemic high in February 2020, despite the economic collapse, and 76% above the low a year ago. This has occurred at the same time as fixed income markets have sold off as inflation concerns mount in the wake of the huge US stimulus package – a fiscal strategy which might have been better served had it been introduced last year.

It remains to be seen whether inflation fears will be realised. However, if inflation does pick up the fiscal stimulus is unlikely to be the only catalyst. Equally important – if not more so – are events in China where demographics mean that it will be increasingly difficult in future to generate big increases in output by increasing the labour contribution. To the extent that the quiescence of inflation over the last twenty years has had more to do with the expansion of low-cost global production capacity in emerging markets than anything that has happened in the industrialised world, events in China will be the key to markets in the years ahead.

One of the potential side effects of the Covid crisis is that it may serve to mask a number of secular trends that we initially ascribe to the events of the past year but are in reality due to other factors. This was the case following the bursting of the Japanese bubble economy in 1990 and the GFC of 2008-09 when a slowdown in population growth resulted in slower potential growth in the wake of the crisis, giving rise to a much slower recovery than anticipated. As we reflect on an unprecedented year, we have learned a lot about pandemics and how to combat them but we have a lot still to learn about the long-term effects on the economy and markets. There is a long way to go before we can contemplate a return to economic normality, and whatever the new normal is, I suspect it will not be like the old one.