Boxed in

Market report

• Still hot inflation data continues to box central bankers into a corner – investors continue to adjust their expectations of the resulting (ongoing) slump in economic activity
• A big weekend ahead for UK politics, with competition for the next Prime Minister heating up

CIO view

The week (and the year so far) was summarised by yet another positive surprise on US inflation. This has, in turn, further fed expectations that the central bankers will have to go even bigger on base rates to bring price pressures back to heal. The knock-on implication that the harder they must go in the short term, the larger the resulting recession will inevitably be, dominated much of the debate and price action this week. So, while short-end interest rates continued to rise, reflecting the need for an even stiffer battle against inflation ahead, longer dated interest rates were well supported on growing appetite for insulation from the next recession.?Stocks moved back towards lows for the year.

There should be little conviction left on the short-term path of inflation. This, as we have highlighted repeatedly, is a huge problem for those looking to express strong views over the summer. Our attempts to measure inflation and inflation expectations will remain in the driving seat for many markets for the foreseeable future. It is hard to imagine stock or wider risk asset markets will turn sustainably until we see clear evidence that victory in the US battle against inflation is assured. We discuss all this in a bit more detail in our main article this week with the real experts – the beginning of a series of interview articles with our in house specialists on the biggest topics of the moment. However, suffice it to say that the team tasked with specialising in shorter term opportunities in the market has much to grapple with for now.

For what its worth, this is also the case for whoever emerges victorious from the Conservative Party leadership race. Whatever is said on the stump box, or indeed in the incoming TV debates, will need to be framed by a macro economic environment that will continue to provide little room for manoeuvre. Those proposing sweeping tax cuts will be aware that no major fiscal action will come without the potential for a monetary response in the current environment. The Bank of England, along with its international brethren, is rightly betting that the best way to help on the cost-of-living crisis is to bring inflation back under control expeditiously. Unexpected fiscal splurges will more likely hinder than help here. Higher short-term interest rates would be needed.

On the flipside, the promises of those of a more libertarian bent need framing in the reality of healthcare, environment, and various other hard to shift expenditures and their likely trajectory in coming years. In any case, the UK government as a proportion of the UK economy has trended in a narrow band since the second world war of between c.35 – 45%. The point here is that the size of the state and its functioning are not as easily shifted about as some of the debate would imply. The state and its role are shaped by centuries of economic, political, and societal weather. A sudden shift to the American model say (where government tends to sit in a rough size range of 25 – 30% as a proportion of GDP), or the French one (where it is closer to 55 – 60% of GDP) should be seen as unlikely.

Remember also to tune out arguments about the size alone of government and its effectiveness or relationship to productivity growth. These arguments have long since been debunked as misunderstanding the nature of productivity. The role of DARPA (Defence Advanced Projects Research Agency) in the US in a range of base innovations in the post-war period is one example of how the state can be important in the innovation chain.[1] The crises of the last several years have also no clear message to impart here.

The point here is not to offend any committed libertarians. However, it should be self-evident that size alone is a very poor indicator of government quality or effectiveness. In any case, we don’t expect there to be much room for anything meaningful on this front for a while. The various threats facing the UK, from war to the cost-of-living crisis to the ongoing pandemic, are likely to dominate the agenda. The ‘events’ that subsumed much of the last administration continue to swirl unpredictably. Invest accordingly – a diversified bet on the medium- to long-term future of the global economy looks attractively priced today.

[1] Mazzucato, Mariana (2013) The Entrepreneurial state – debunking public vs private sector myths. Penguin books

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