Monday digest

Posted 4 October 2021

Overview: September departs with rising bond yields making a return
A shortage of gas and oil around the globe – leading to rising energy prices – led many commentators to draw parallels with the 1970s oil shock last week. More important, though, was that the topic rising yields making a comeback, having been notably absent since Q1 of this year. This time, however, the narrative was about stagflation rather than economic overheating. As a result, stock markets ended September in just as unhappy a mood as they had been throughout the month.

Fears of a faltering economic recovery coupled with rising prices leading to persistent higher inflation were understandable, particularly given the recent experiences of many people (particularly motorists) in the UK. However, the bond market movements of the past week suggested a different narrative, namely that the rise of longer-term bond yields, rather than shorter ones confirms expectations of continued economic growth as expressed by the latest central bank statements, while inflation pressures – while certainly painful – are still only transitory. Regardless, rising yields are seldom greeted positively by equity markets, so the month closed on a low for investors.

Even so, despite the gloomy crisis talk, and stock markets having given back most of what they gained over August, the overall message was not an entirely negative one. The cyclical recovery is on track and with it a gradual upward normalisation of yields – even if there may be a bit of a hiatus over the coming months as supply issues need to be resolved.

As noted last week, such post-recovery periods that follow recession are often characterised colloquially as ‘climbing the wall of worry’. But we take heart from last week’s seeming shift in sentiment towards the cyclical recovery theme, even if the winter months may prove somewhat nerve-racking.

Germany votes for change – of the orderly kind
The other big story of the week was the German general election, which as anticipated, did not turn into a market-moving event. Germans want a change. That much is clear from the election result, which saw the ruling Christian Democratic Union (CDU/CSU) poll worse than ever before. Unfortunately, the exact change voters want is much less clear. The centre-left Social Democratic Party (SPD) won the greatest vote share but at just 25.7%, this shows just how fragmented the electorate has become.

Whatever government emerges is almost certain to include the next-biggest parties: the Greens and the Free Democratic Party (FDP). Both increased their vote share from 2017, and together represent more than a quarter of German voters. This makes a coalition between the SPD, Greens and FDP the most likely outcome of forthcoming coalition negotiations. If it indeed ends up that way, markets may be quite happy to see two forces for fiscally driven change (SPD and Greens) being held in check by a party opposed to state intervention and tax rises. This sounds very much to us like an emerging change agenda built the German way.

German fiscal policy is the main political concern here for international investors. It is, unfortunately, also the main site of disagreement. Not only is the FDP committed to lowering taxes, but it is also firmly behind the ‘debt brake’, which limits the amount of government borrowing. This is incompatible with the Greens’ position – which calls for a loosening of fiscal policy as well as higher taxes for those on higher incomes. The Greens’ environmental investment drive would need to be paid for one way or another – either through tax rises or increased debt. Party leaders have said they are willing to accept the debt brake, provided it is supplemented by a new investment rule. The FDP, meanwhile, suggests government funds could be diverted through other areas, and are eager to mobilise private capital through climate and infrastructure related tax breaks.

International media coverage has been somewhat pessimistic about the election result – pointing to the loss of Angela Merkel and a fractured political landscape in a country long-renowned for its stability. But there are plenty of positives too. The fact that Olaf Scholz looks likely to be Chancellor only adds to this positivity. He is a veteran of government and is likely to retain the stability seen during the Merkel years. By his side would be politicians eager to make big changes and modernise Europe’s largest economy. These are all positive signs for markets to be excited about.

Business investment: why capex remains key
While consumption and household spending have been key factors to watch throughout this year’s recovery, equally important is investment in the post-pandemic future. So far, governments have looked like the main architects of that investment drive. President Biden is planning a wave of infrastructure catch-up spending in the US, while British and European politicians are exploring similar measures with a focus on green infrastructure. Fiscal policy taking the lead here makes sense: the combination of high private savings levels and historically low interest rates put governments in a good position to spark growth through public spending, while the cost of such investment should stay low for some time.

But for a stable and sustained recovery, investment needs to come from the private sector too. Economic activity demands new technologies and avenues of production (particularly in the face of the daunting environmental challenges), and public spending can only go so far. When businesses focus on capital expenditure (capex), it is a sign that growth is self-sustaining. This is vital for ensuring a broad-based recovery – avoiding overreliance on consumer confidence or individual sectors. Capex also indicates businesses are confident about the future. There is little point investing in new products unless you think people will be able to buy them. So, if we see strong capex spending it follows that corporates are confident about the economic recovery. This is particularly important now, considering how the pandemic experience has altered perceptions of productivity and technology across society – from online infrastructure to the green transition. Most of the capex recovery has gone into information technology (IT), while other sectors have seen their corporate investment levels fall. Optimists would say IT investment is the most needed – particularly for the so-called green revolution ahead. As written before though, new technologies still need more materials and old-fashioned infrastructure to work. Fortunately, governments seem eager to provide on the infrastructure side.

As such, the outlook is mostly positive, even though capex intentions have dropped off recently. Companies flush with cash – like the US mega-tech sector – can fund spending out of their reserves, or have access to raising funds at low yields in capital markets. Others must resort to bank loans. The outlook for those companies is unfortunately less positive, with bank loans not recovering as much since early 2020. The main risk to the overall picture is what the current supply shock might mean for investment intentions. As noted, the energy crisis and widespread supply bottlenecks this year are mostly one-off affairs, unlikely to cause elevated inflation over the longer-term. Short-term price shocks can still have a big impact on confidence, though. Should price issues eat too much into corporate profit margins, it will make companies less likely to invest – weighing down on future growth prospects. For now, companies are absorbing the costs, but this is something worth keeping a close eye on.

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