Posted 28 June 2021
Overview: Calm markets shine light on future growth
After the Federal Open Market Committee (FOMC) indicated the US Federal Reserve’s extraordinary support for the US economy may last months rather than years, discussion last week turned to speculation on the internal battle between the committee’s hawks and doves. However, Fed Chair Jerome Powell’s very dovish remarks during his testimony to Congress suggested the doves will continue to hold sway in the near term. Investors may have to wait for late August for news on possible reductions in central bank bond purchases, but for now, they can content themselves with the likelihood that their portfolios will end June with another positive monthly contribution.
In the UK, the messaging from the Bank of England was also as dovish as could be, considering recent inflation surprises. There was much talk – like in the US – that current price rises were simply inflation of a transitory nature and, after a long period of undershooting rates of inflation, nothing to worry too much about. Central bankers on both sides of the Atlantic are in a better position now to defend their continued unconcerned stance compared to a few months ago. While the global recovery is still showing all signs of remaining on track, there are now far fewer likely surprises that could stoke fears of overheating. This is not hurting markets on average, but the more cyclical sectors have ceded ground again to the secular growth winners at the top of the NASDAQ. The tech-heavy US index edged to new highs almost every day last week, ensuring US markets are again outperforming global counterparts.
For us, the bigger debate is whether the economic growth story can move on from the COVID rebound into an extended run of investment. This would require sustained public investment but, we need to see private sector credit demand start picking up first, given how long public projects tend to take to get underway. There are small signs among consumers of increased borrowing, but companies are still lagging after last year’s forced borrowing. Business investment intentions (capex) remain high across the world, constrained perhaps by supply limits rather than lack of confidence in the sustainability of the recovery.
Inflation isn’t always inflationary
The inflation debate has become a little – well – inflated lately. Everyone has an opinion, ranging from forecasts of deflationary sluggish and stubborn growth to a new age of supercharged prices on the back of an overheating economy. Most central banks are still feeling dovish about the post-pandemic world – preferring to describe price rises as transitory inflation, although last week the Fed appeared less certain how transitory such price rises are. Nevertheless, most major central banks in the developed world are keeping monetary policy loose, rather than pre-emptively choke off inflation and with it potentially a lasting economic recovery.
The recovery is underway, but the road ahead is long. For inflation to stay at a high level, consumers need to be confident about their prospects – but that confidence takes a long time to build. Coming out of the sharpest global recession on record, it will not happen overnight. Judging from recent market moves, investors seem to agree. Breakeven rates (an indicator of inflation expectations) climbed earlier in the year as concerns spread of an overheating economy, but these have since flattened off. Similarly, while flows into cyclical stocks rose (those that stand to gain from higher prices) a few months ago, this trend has evened out lately, and the ‘reflation’ sectors have not been the biggest winners in recent weeks. In short, markets agree with central bankers: the recovery is going well, but it is too soon to worry about overheating.
Interestingly, recent price rises could themselves act as dampeners on inflation. That may sound confusing, given inflation is nothing more than rising price levels. But when you consider where that inflation came from – supply-side constraints – it makes more sense. The fact that costs are going up means demand will fall. In other words, even though inflation is nothing more than rising prices, rising prices are not necessarily inflationary.
None of this is to write-off the prospect of more inflation. The post-pandemic economy could well run a little hotter than the pre-pandemic one – certainly if consumers spend more of their savings than currently expected. But it is still unlikely that inflation will stay at dangerous levels over the long-term. A continued increase in global prices is a risk, but it is far from a certainty that after years of undershooting, even a slightly more than transitory period of overshooting will herald the beginnings of an inflationary decade.
Europe’s green deal
How much is a ton of CO2 worth? Quite a lot these days, as it turns out. Amid the good mood in capital markets, there has been a notable rally in European and British carbon prices – with a ton of CO2 (or equivalent emissions) now purchasable for around €55. That is a 60% increase from back in November, and an almighty jump from just a few years ago. For those unfamiliar with the intricacies of emissions trading, this begs the question: why on Earth would anyone pay for a ton of carbon?
The answer lies in the EU’s Emissions Trading System (ETS), a financial market set up to allocate polluting rights to European companies (Brexit has meant the UK ETS is separate but almost the same). The basic idea is that polluters must own a certificate for every ton of CO2 they emit. These allowances are auctioned off by the European Commission daily – with the total supply determined by the EU’s environmental targets. For energy and industrial companies, the reason for buying carbon credits is straightforward – to carry on their usual polluting activities. In that sense, carbon credits are a lot like an emissions tax – designed to put the social and environmental cost of emissions onto the producers themselves and incentivise them to reduce them as much as economically viable.
However, the inclusion of voluntary buyers, especially financial companies and investors, makes the ETS operate entirely different to a tax. Investment funds are not required to hold allowances, and may have environmental goals, but are probably still seeking to make a profit by trading with polluters or speculating on future prices. That extra demand drives up prices and makes the ETS a commodity market like any other – where prices are determined by the balance of supply and (now increased) demand, factoring in future expectations.
Investment in carbon credits is becoming increasingly mainstream, and for good reason. Given the total supply is set by the EU’s political targets, many feel the price is simply a one-way bet. This makes a vast change from when the ETS was first introduced in 2005. Back then, a huge stock of allowances was merely handed out to energy and industrial companies, giving them little incentive to buy more and holding prices down. Industrial firms still receive free permits regularly, but the amount handed out has been drastically reined-in in recent years. But the European Commission has a new plan: The Carbon Border Adjustment Mechanism. Set to be unveiled next month, this plan would tax global competitors at the EU border for the carbon they produce. Officials in Brussels hope the tax will protect European industry at the same time as prompting producers around the world to go greener. For supporters it is a way of levelling the playing field against unfair advantages worldwide, for the critics its yet another barrier to free trade.
From an investment perspective, the interesting part of this is how it feeds into the growing deglobalisation movement experienced over the last five years. After decades of globalisation and increased trade, we are now moving increasingly toward regionalisation – whether that be for nationalist, security (in light of COVID) or indeed environmental reasons. It may well be that, once these measures are introduced, we could see them being used for more stereotypical protectionist goals – such as regional job protection. This would be a long-term inflationary pressure and could significantly change the structure of the global economy. Regionalisation might well be another political objective which some voters want. Those voters may not be natural bedfellows with the environmentalists, but the outcome may help them pay the price for decarbonisation.