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Economic and Financial Market Update: The economy is improving but there are bumps

19 March 2021

Summary:

The economy is improving. But there are bumps;
Supply-chain problems are one of them. They are likely to be only short term.
Proposed longer-term solutions are more problematic;
Households are likely to reduce their saving. The main game is to increase wages growth.
Business investment is currently too low. In time it will rise.

Last year there began a discussion as to what firms might do in response to supply-chain problems. One view was that firms could hold a higher level of inventories. Firms have not built up bigger stock piles partly because it is currently hard to lay your hands on big pile of extra goods. But the other issue is that holding additional stock is a big cost.

An alternative thought to mitigate supply-chain problems is to increase the amount of goods manufactured domestically. The Government has set aside some money to do that. But the import-to-sales ratio remains near its historical highs. The reason why we import so many manufacturing goods is that other countries can do it more cost efficiently than we can.

A related suggestion was that we need to diversify our imports away from China. But China has actually increased its share of the global export market over the past year. Partly that reflects that China has handled COVID better than most countries so has less domestic restrictions on its economy. It also reflects that China happens to be a very efficient producer.

The domestic household saving ratio is likely to decline further. How far will depend upon a variety of factors including consumer confidence about the jobs market and the pace of wages growth.

Running down saving means that household consumption growth for a period can grow faster than income growth. But that process can only go on for so long. For consumer spending to stay strong for any sustained period requires stronger wages growth. The February unemployment rate reading of 5.8% highlighted that the jobs market is in a lot better shape than even the most optimistic forecasters thought possible six months ago. In time this should mean better news on the wages front.

As often happens during recessions business investment is currently weak. Firms uncertain about the economic outlook are unlikely to make big capex commitments. Relative to the size of the economy, the most significant decline in investment over recent years has been non-residential (reflecting the end of the mining boom). There has also been a fall in plant and equipment investment. Disappointingly, there has also been a trend decline in R&D investment. The big positive though has been the significant uplift of investment in digitization.

The stronger economy and government incentives means that capex spending is starting to rise again, notably on plant and equipment. If economic growth is strong over the next 1-2 years continued strong business investment is likely.