This growth scare will pass – but it might make the Fed stay its hand

Markets are having a bit of a growth scare.

On the one hand, the Delta variant of Covid-19 is proving difficult to throw off.

On the other hand, the Federal Reserve, America’s central bank, has taken a turn for the vigilant, and appears slightly keener than markets had thought on the idea of turning down the money-printing presses.

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But these two contradictory positions can only hold for so long.

A growth scare might rattle markets, but it also means “looser for longer”

Australia and New Zealand shutting everyone back in their homes as a result of a handful of Delta cases is just the most dramatic illustration of the problems the world is having with the coronavirus.

Covid is not as deadly as it was (or rather, vaccines have taken that edge off it). But it’s still disruptive, and while the UK, the US, and Europe are getting their act together vaccine-wise, lots of countries still haven’t.

More to the point, the countries that haven’t are taking a real zero tolerance approach to the virus. That means more supply chain disruptions and all the rest of it.

It also means that economic growth will take a hit in some places and also that, overall, the idea that we’d get back to “normal” once vaccines had arrived is retreating ever further into the distance.

So it’s little wonder that in recent months we’ve seen the reflation trades (such as commodities) take a hit. Then markets have been given an added scare by the idea that the US central bank might start to rein in the money printing.

There’s a bit of a self-correcting mechanism at work here though. Because the thing is, a growth scare is also exactly what the Federal Reserve needs to give it an excuse to be more cautious than markets are currently expecting.

You just need to look at New Zealand to see that. The one-case-lockdown also resulted in the New Zealand central bank dropping a planned interest rate rise.

From that point of view, it’ll be interesting to see what happens at the Jackson Hole conference in about a week’s time. But one scenario I can see unfolding is that, having rattled the market by being a bit more aggressive than expected in recent speeches and meeting minutes, we might get Jerome Powell pulling back and emphasising the Delta variant, and the long slow process of recovery.

Markets might then decide that it’s time to start looking on the bright side again.

I think we’ll see inflation and that it’ll last longer than investors currently expect

My own view remains basically the same as it has all year.

Developed-world consumers are – on average – in a good position, particularly relative to the aftermath of a typical recession. And developed-world consumers (led by US consumers) are one of the most powerful economic forces in the world. So it’s hard to be too bearish on the economy.

Meanwhile, the supply of goods and services that they consume is more restricted than usual. I’d expect that to pass in time, but it might be a much stickier process than anyone expects. We are moving from a “just-in-time” world to a “just-in-case” one (I’ve stolen that from someone but I can’t remember who – apologies if you coined it).

Overall, that implies a permanent (or certainly longer than just a blip) drop in efficiency, if by “efficiency” you mean a system with virtually no redundancy built in for emergencies. That in turn implies a more expensive system.

So we can expect a bounce in inflation in the short term (at least) from that recovering demand meeting impaired supply. This is already very obviously happening.

However, we also have an impaired supply of labour. The mechanism isn’t entirely clear – I’ll suggest some reasons in a moment – but employees finally seem to have discovered some bargaining power after years of capital very much having the upper hand.

One reason for this is that consumers are nowhere near as financially impaired as they would normally be coming out of a recession. That means they can be pickier about to whom they rent their time, and for how much.

Not only that, but a lot of people have either been forced by circumstance, or simply been able to take the time, to swallow the switching costs of looking for another job, and have realised that their skills are worth more than they thought. Anecdotally at least, the reason the hospitality industry is struggling right now is because lots of people realise they can get more sociable hours and less physical work, and get paid the same or more.

Of course, there’s also the fact that labour mobility has collapsed. Entire industries have shaped themselves on the assumption of a “just-in-time” workforce in the shape of immigrant workers who are happy to work unsociable hours in insecure or seasonal jobs for not a great deal of money.

The removal of that labour source is most obvious in Britain where we’ve had Brexit as well as the pandemic, but the knock-on effects will go well beyond implications for pay.

Anyway, what this all adds up to – in my view – is persistent inflation that will last quite significantly beyond what markets or central banks are currently betting on.

Right now, that’s absolutely not the case for markets. So if you want to pick up some inflation-insulating assets for your portfolio, I suspect that now is a good time to do it, before the market starts to get worried about it all over again.

We’ve been writing about this a lot in MoneyWeek magazine – so do subscribe now if you haven’t already. You can get your first six issues free here.