Think at London Business School
How can asset managers successfully navigate global market shifts?
By Richard Portes, Anna Pavlova, Seb Murray
The UK is looking at a prolonged period of economic hardship caused by rampant inflation, supply-and-demand pressures and rising interest rates, as well as stagnant productivity and a drop in labour force participation. These were the conclusions drawn from a virtual and on-campus event exploring the cost-of-living crisis hosted by the Wheeler Institute for Business and Development at London Business School.
Setting the scene, Andrew J Scott, Professor of Economics, underlined the origins of the cost-of-living crisis, which include a longer-term squeeze on the standard of living in the UK. “These are pretty deep-seated problems we’ve got: they’re about long-term growth, structural trends around inequality and now an adverse shift in the terms of trade due to higher energy prices which may persist for some time – these seem like very fundamental, long-term problems to deal with.”
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Linda Yueh, Adjunct Professor of Economics, underlined the risk of a return to what is called “stagflation” – the painful mix of high prices and low growth that was experienced in the 1970s following the Arab oil embargo which sent inflation soaring to double-digit rates even as economies around the world stalled.
While she accepted the shock from the Russian invasion of Ukraine was reminiscent of the 1970s because it has pushed up energy prices, she said there were differences between then and now. She highlighted that “core inflation”, which excludes volatile energy and food costs, is seen as the best indicator for inflation’s future trajectory.
“That’s the debate… how much of the inflation is still there even once these price effects have gone,” said Dr Yueh. But she added the pandemic and in particular China’s strict zero-Covid policy that has choked global supply chains is contributing to “this feeling that maybe we are looking at a period of stagflation.”
More widely on China, she highlighted how a slowdown in the world’s second-largest economy could ripple across the world. The west’s close security ties to the US, she added, could contribute to global fragmentation since these nations are expected to align with the US in matters concerning China. Overall that could itself generate challenges around trade and potentially make it harder for the UK as a trading nation to manoeuvre and export its way out of an impending recession, she said.
Another economic woe for the UK is the mortgage market, as highlighted by Paolo Surico, Professor of Economics. He said that, unlike in the US, the most popular mortgages in the UK are two-year fixed-rate deals. That means that, “between the end of this year and the [end of] 2023 there will be more than 2 million households coming up to refinance their mortgage” and they are “going to face interest rates that are between 4% and 5% higher than they used to be just two years ago”.
Moreover, Professor Surico added that his own research has shown that “households with a mortgage are the ones that cut their consumption more following an interest rate increase”.
But the problem does not stop there. The economist added that 40% of small and medium-sized enterprises — the backbone of the British economy — secure their corporate loan against residential property, or personal guarantees on the home value of their director. “From my own research, I show that following an increase in interest [it is] the young SMEs that contract their borrowing most through the house price channel. And when they cut their corporate borrowing, it also cuts their investment,” said Professor Surico.
This shows that monetary policy faces a difficult trade-off between inflation and real income, said Lucrezia Reichlin, Professor of Economics. She suggested that, while it can be argued that the Bank of England moved few months too late to tame inflation, it is now going too fast. The UK is facing both a term of trade shock and a demand shock, partly caused by fiscal policies implemented during the Covid crisis.
Insofar as inflation is caused by supply, “monetary policy does not have much power” since it acts through demand and financial conditions. The effect on demand is already working itself through the economy but monetary policy acts with a lag. Given the current stance, the UK economy is in a recession and we will see negative growth in 2023.
That situation has been worsened, she added, by a misalignment between UK monetary and fiscal policy following the turmoil in government bond markets following former chancellor Kwasi Kwarteng’s £45 billion of unfunded tax cuts. That caused the pound to plunge and the Bank of England to intervene in the bond market to stop a slump in the price of gilts, which threatened the stability of pension funds.
Although these measures have largely been reversed under a new administration, Professor Reichlin said they had “damaged the credibility” of UK leadership. “The UK has a problem of governance and I think it is very challenging.”
Another challenge for the country is the “productivity puzzle”, the slowdown in growth in output per hour worker since the 2008 financial crisis. Professor Surico said this is caused by underinvestment, but not in the areas most people expect. Based on his own research, he believes that investment in public research and development (R&D) would deliver the greatest productivity gains, over and above education and infrastructure spending. He said public R&D “generates the seeds for private innovation, which then are followed by a boom in productivity”.
More broadly, the panel highlighted a drop in labour force participation, which is still below pre-pandemic levels despite the current high employment rate — something that has been attributed partly to health concerns.
Professor Scott said: “We’ve got an older population who were accounting for a great deal of employment growth in the 10 years before COVID; people aged over 50 accounted for 80% of the employment growth in the UK. Something strange has happened since Covid: a lot of them have withdrawn from the labour market and I’m not sure we fully understand that, but health seems to be a major challenge.”
However, he saw a strong possibility that people could “unretire” in the near future out of economic necessity. “We already knew before COVID that one in five people unretired. And I suspect we’ll see that as a trend because we’re living longer lives. If income growth is less, you’ve got to bring more lifetime income in.”
Looking ahead, Professor Surico said that, while there was no “silver bullet” for how firms could survive the recession, there was some evidence that the difference between the winners and the losers will come down to productivity.
The event was supported by The Wheeler Institute for Business Development.