I was playing golf in Scotland last week – I’ll explain why the wages of dish washers make it more likely that the Bank of England will raise rates sooner than the market expects. We’ve had weaker growth and the promise of higher taxes here too while I’ve been away. It’s a similar pattern in the US but the impact there might be bigger – and bad for equities.
Covid is still the dominant influence on markets but it’s hospitalisations rather than new cases that matter. There are worrying signs for the US as you can see from the chart below.
Vaccination rates and mask wearing are lower in the US, especially in Republican states. With students back at school and winter approaching things will get worse but we do not expect significant lockdown restrictions to be imposed. ‘Get a jab’ is the message in the US, as they and the rest of the world learn to live with the disease The hospitalisation numbers are lower in the UK and much lower in most of continental Europe but need to be watched carefully.
Tapering priced in – markets will focus on rate hikes
The US Federal Reserve meets next week, and I expect them to confirm that they plan to start to taper bond purchases at year end. That’s all priced in now. The markets’ focus will switch to guessing when we’ll get the first hike in the Fed funds rate. That depends of course on inflation and employment. Figures out this week may show that inflation has cooled a bit in month-on-month terms but it remains well above the 2% target, it’s employment that is holding the Fed back from pulling the trigger on a rate rise. The latest employment figures were disappointing. The increase was one quarter of a million but that was one third of the market’s expectation and means total jobs are still more than 5 million below pre-pandemic levels.
Supply, not demand, is the issue for US labour markets
But we expect a big improvement in the labour market in the months ahead. Many younger workers in the US took the summer off and enjoyed enhanced unemployment benefits that were often higher than paid work. Those have now ended. Initial unemployment claims have fallen sharply in recent weeks, a trend that we expect to continue. With surveys showing huge vacancies, it’s supply not demand that is the problem.
Increase in US spending, but also taxes
Meanwhile, the infrastructure bills are wending their way through Congress. They involve huge spending but the market impact will depend more on the associated tax rises. Early drafts included a hike in the rate of Corporation Tax from 21% to 28%. The latest proposal pares the increase back and we expect the final rate to be 25%. That’s still a hefty increase. Together with the increase in foreign income taxes, the hit to S&P earnings next year could be around 5 percentage points. We reckon that less than half of analysts have factored that into estimates.
Headwinds to slow, but not stop, UK recovery
Here in the UK, the recently announced increase in National Insurance rates, the end of the furlough scheme and the cut in universal credit, will all slow but not stop the recovery. Consumers still have a big ‘Covid piggy bank’ from past government support. They have the money to spend and as schools re-open, we expect employment to pick up too. The Budget on 27 October will include more government spending on the levelling up agenda.
As in the US, it is lack of supply that is holding back employment, not demand. And wages are rising too. Dish washers in St Andrews are being offered £20 an hour, a huge increase on pre-pandemic levels. Pre-Brexit, the limitless supply of workers from Eastern Europe has gone – I saw hardly any last week in the hotels and golf club bars. Headline inflation will fall in the UK over the next few months due to base effects, but wage pressures are building and the Bank of England is likely to raise rates next spring as underlying inflation picks up.
Less bullish on equities
What does this all mean for equities? Higher taxes and higher inflation are bad news for markets. I’m less bullish about equities than I have been all year. I reckon we’re due a correction of perhaps 10%. But that would be a buying opportunity. Capital expenditure is booming in the US and that means higher productivity and stronger earnings. It’s notoriously difficult to time market turns and I do think equities offer superior longer-term returns. But I’d lock in some gains and be cautious as the year-end approaches.
My webinar on 30th September will explore these issues and others in more detail, and there’ll be another video next week.
Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.
The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.