Monday digest

Posted 22 March 2021

Overview: the tug of war between optimism and fear continues  
This week marks the one-year anniversary of the turning point of the COVID stock market crash. This time last year, we were writing about a “plunging into a global recession of potentially unknown proportion and duration”. It is therefore worth noting that one year on, the picture is so much more positive. The global economy remains intact, and – once the pandemic finally retreats – near-term growth prospects look strong – driven by the likely unprecedented demand spike. Even so, with stock markets having already priced in a considerable amount of what recovery hopefully lies ahead, there’s – somewhat paradoxically – still much to be anxious about. 

As we have noted, the massive bump in US activity has dominated discussions about spillover effects into global growth, which has led to a sharp rise in long-term US bond yields, which has in turn dragged up yields elsewhere. In Europe, COVID infection numbers are rising again and, unfortunately, this appears to be down to greater transmission rather than more testing. On the other hand the vaccination pace has started to increase, and there is some good news in that the vaccines also appear to be reducing the overall impacts of catching the illness, while renewed lockdowns in Italy and France should bring some stabilisation. Meanwhile, Asia has also had some of its confidence shaken by what appears to be a small COVID resurgence – at a much lesser level than Europe, but enough to keep consumers from enjoying the oncoming spring. 

This is a period without real historical reference, and 12 months economic data will be affected by the very same base effect that investors currently experience for their investment returns. This is likely to create considerable confusion and nervousness that may lead to continued volatility in capital markets. Over the next few months in particular, we can expect extraordinarily high annual economic growth rates, as well as higher reported inflation numbers, almost entirely as a result of the comparison to where we stood a year ago. Thus far, stock markets are still making upwards progress. However, yields rising on economic overheating fears on the one hand and on the other hand concerns that forecast growth rates may potentially not materialise as soon as anticipated are leading to market swings that remind of a tug of war between these opposing sentiment drivers. We expect that the moderation of near-term growth sentiment will lead to both a consolidation of recent upward yield momentum, as well as a calming of stock markets. 

Nevertheless risen yields and the growth rebound prospects for the cyclical, non-digital parts of the global economy is creating different winners and losers compared to last year. While this should not prove too much of an issue for holders of widely diversified investment portfolios, those investors with more concentrated exposure to particular regions, industries or investment styles are experiencing a reversal of fortunes compared to last year. 
 
Markets still doubting the new-look dovish Fed  
Interest rates are on hold for years to come, according to the latest post-meeting announcement from the US Federal Reserve (Fed). This comes despite upgrades to the Fed’s own economic forecasts, which now plot a stronger path out of the pandemic for the US economy. Capital markets responded positively to the Fed’s structurally dovish move at the time, expecting easier financial conditions and a more supportive environment for the near future. But doubts are creeping in, as improving growth expectations have led many to believe support should be withdrawn earlier than suggested. That the Fed has stuck to its guns and signalled zero interest rates for several years is therefore a good sign. 

For observers fearing a rerun-of the inflationary 1970s, it may be re-assuring that price stability is still the Fed’s mandate, as well as ‘moderate long-term interest rates’, as defined by the Federal Reserve Act in 1977. The translation of those objectives into the economy has changed towards a greater weighting of full employment but, in fact, will be re-assessed every five years. We would also point out that financial stability – which would include debt driven asset inflation – has found its way into the current monetary policy strategy. Improvements to the growth outlook are a test of that new resolve.  

Rising bond yields indicate that bond investors believe the Fed will have to raise rates sooner than it says it will. Powell and co have repeatedly stated their desire to keep conditions loose, but markets seem to not be buying it. This is a problem for the Fed. Amid the deepest global recession on record and, despite some positivity on the horizon, the economy still needs a big helping hand to reach normality again. Keeping policy loose and liquidity abundant is therefore a must, but rising bond yields have the natural effect of sapping available capital away, as the ‘risk-free’ rate of return increases – effectively leading to a tightening of financial conditions by means of market forces, not central bank intervention.  

For the Fed, then, communicating its dovishness is key. But with a new policy framework now in place, markets still do not know how the Fed will react to incoming news. Indeed, policymakers themselves seem somewhat unsure of what its new ‘reaction function’ should be. For the moment, the Fed’s answer is that inflation will return, but will only be transitory and therefore contained, even with the added charge of fiscal stimulus. In the current environment, we should expect the recovery to be somewhat volatile, with base effects from last year making jumps look bigger and slowdowns more abrupt.  

In keeping rate expectations down despite stronger growth forecasts, policymakers are telling us they plan to look through this volatility, toward the longer-term picture. Similarly, the Fed’s best guess on the fiscal front is that we will not see a sharp rise in employment, and that the scarring effects of the virus recession could persist for some time. We expect recent market volatility to continue, but as long as the economy actually improves there is not much to suggest this will create a more lasting downdraft effect – as long as central banks stay true to their word and stick to their steady course, even when price levels pick up. 

Greensill collapse leaves backers green around the gills  
The collapse of supply chain financer Greensill Capital has all the hallmarks of a classic business scandal. Once hailed as a shining example of the UK’s fintech start-up potential, Greensill attracted attention from international giants such as Credit Suisse, hedge fund manager GAM and private equity house Softbank, and even managed to snag former Prime Minister David Cameron as an advisor. But it is not just the reputations of those who lent their names and money to Greensill on the line. While the company’s demise will not cause systemic weakness for the wider financial world, it could have a big impact on many businesses in industry and trade. 

Greensill generated handsome profits by exploiting ‘factoring’ an age-old type of financing not well-served by the banks. With increasing demand for low-risk positive cash returns at a time when Eurozone banks were charging (rather than paying) for traditional deposit taking, Greensill expanded its operations over time beyond traditional supply chain financing, and started looking for all it could to package in its products. It faced a choice of competing for other low-risk assets with slim margins, or looking for higher-risk higher margin assets. It chose the latter. By their nature, the assets were short term but constantly being rolled over for short periods, which lessened credit risk. The result was that in the end, more and more higher-risk long-term financing was sold as short-term ‘sure things’, only for the investors involved to be left carrying the can when the truth emerged. 

Greensill’s products were sold as highly liquid, but given their underlying nature, they ended up with a heightened lack of liquidity. Because of this, and the general lack of investment grade exposure, Greensill investors are likely to sustain significant losses. Regulators, including Germany’s bank regulator BaFIN, will also face some difficult questions, which is particularly damaging given the Wirecard fraud was uncovered less than a year ago. UK regulators will also need to examine how corporate finance should be monitored in future, although the fact that the funding came from offshore institutional investors might make it less problematic. 

Ultimately, the Greensill story is a familiar one of excitement over an innovative financial instrument turned to greed – people chasing the perfect return scheme and pretending they have found it. It is far from the first story of its kind and, unfortunately, will not be the last. The financial system is currently swimming in liquidity, a good thing for the global economy, but ultimately one that is ripe for opportunism. There is no escaping the truism: caveat emptor. 

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