Central banks struggle with messaging
Posted 12 November 2021
Following five weeks of global equity markets inching higher every week, risk asset markets slowed even though, for once, economic data was actually offering reasons to believe that the worst of supply chain constraints may be behind us. From as far as we can make out, it was once again the bond markets that distracted stock markets. We feature a separate article this week on the topic, because we had the unusual combination of inflation adjusted yields falling and nominal yields rising slightly. What can be read into this, is that inflation concerns continue to rise, but there is now less of an offset through rising growth expectations.
If this single week’s observation was to turn into a trend, this would be bad news for both bond as well as equity investors. We suspect though that market participants are currently struggling to get their collective heads around various slightly unusual factors that characterise this post pandemic lockdown recovery, and are quite different to previous economic rebounds.
We have written at length about the price and growth pressures the supply chain constraints have caused. Normally, it is overheating demand rather than struggling supply that causes inflationary pressures, but when economies are so radically switched off and on again, it appears that the resulting upheaval takes longer to settle than many had thought. Central banks are mandated to prevent inflation or risk losing their credibility, regardless what caused the inflation in the first place. As a result and after the first inflation reading from the US of over 6%, there is now a growing concern that they will be forced to tighten monetary conditions and cause a premature end of the economic cycle that is just getting going as flows of goods are beginning to normalise. That would indeed be bad for growth!
It looks as if these concerns are well founded because central banks have already signalled that they will reduce their monetary support for the economy. Unfortunately, they have not done the best job of helping markets to differentiate between the removal of their extraordinary pandemic support and outright monetary tightening. The extraordinary pandemic support in the form of quantitative easing that helped us get through the economic void of the lockdowns is no longer required. The private sector is now paying salaries again, ending the need for furlough support, so it therefore seems right to taper down those ongoing liquidity injections. Rate rises on the other hand would go beyond monetary normalisation to pre-pandemic conditions, but they are still only on the time horizon of sometime towards the end of next year.
The combination of slowing economic growth due to the supply chain issues, combined with the perceived prospect of monetary tightening, has led to bond markets pricing in much lower medium term growth expectations for the coming years than the previous consensus only a few months ago. As unusual as the specific circumstances of the current economic upswing are, just as commonplace are the concerns that accompany the transition from immediate recovery to mid-cycle – ‘climbing the wall of worries’ – as we have referred to before. However, the more upbeat economic news of the week has reinforced our assessment that this cycle is well entrenched, and more likely to surprise, with growth rates next year to the upside than the downside.
In other news, the ongoing COP26 in Glasgow is generating some interesting developments. Most important for us was the surprise announcement of a bi-lateral agreement between the US and China to cooperate in their endeavours to reduce global warming emissions. Being the two biggest emitters on the planet this is not only great COP26 news, but is also providing hope that China may be slowly emerging from the isolation they have put themselves under since the pandemic started. This would therefore also be positive for China’s contribution to global growth, which most (us included) had written down to ‘negligible’ for this cycle.
We also observe a growing positive momentum toward harnessing the might of capital markets in fighting climate change, which we welcome. However, the impression that has also come through at times that it is the responsibility of global investors to solve the climate challenge displays a certain naivety of the function of finance in society. If economic frameworks for addressing climate change are created that require funding and also offer commercial opportunity then the invisible hand of markets will be a powerful ally. Creating such a prerequisite framework is within the gift of global societies and the politicians they elect. Capital markets are a tool that can be very efficient in furthering collective aims of society, but they are not a parallel force to the political executive of societies that can fix problems on its own.