Monday digest

Posted 25 October 2021

Overview: behind investor optimism lies a plethora of risks
Last week, capital markets continued to recover from the downward drift experienced at the beginning of October. Commentators have attributed this slow rebound to strong Q3 corporate earnings announcements – preferring to focus on the positivity of backwards-looking results, rather than more mixed outlook statements. Many companies have warned that supply constraints will continue to hold their businesses back, while at the same time stating they expect demand to remain robust throughout, given the relative financial strength of consumers and companies. This may also explain why margins have until now not suffered under higher input prices, with demand strong enough to allow businesses to pass on input price rises through price rises on their own products.

The business sentiment barometer of purchasing manager indices (PMIs) paints a similar picture. PMIs have hardly declined from their previously dizzying heights earlier in the year and, in the case of the UK, have even exceeded expectations, despite all the supply chain disruptions and labour shortages that business have had to endure. Even more surprising, perhaps, is that this came against the backdrop of declining retail sales numbers over September. Ordinarily, inflationary periods tempt consumers to buy now rather than later, given deferring purchases costs money. Despite all the clamour about inflation becoming engrained, this type of behaviour does not seem to be taking hold (with the exception of car fuel in the UK perhaps, although there are forces other than price in play here). Whether this deferment of purchases is simply a result of a lack of availability or is based on the expectation of a return of lower prices down the road is not entirely clear. Brexit and pandemic effects have teamed up to leave the country with higher bills for imports and fewer workers to keep the supply chain moving. Panic buying has also turned some supply bottlenecks into full-on blockades. But inflation is far from just a British problem. There are well-documented supply shortages all over the world, from computer chips to oil and gas. In Europe, a lack of energy supply is threatening to cause rolling blackouts. In China, those blackouts have already been a reality – caused by a sharp coal shortage and inability to keep factories running.

Even without strong growth, supply shocks will have an impact on consumer expectations and wage demands. This could entrench inflation pressures, which would then present a real challenge to policymakers. Should they act to quell price hikes while growth is still fragile, it could be very damaging to the global economy. In our view, that is one of the main risks to economic outlook. Investors are in good spirits now, but underneath that optimism is a plethora of risks. It might not take much to make markets fearful rather than hopeful, and a premature rate hike from the Fed or ECB would likely do the trick.

Has the Bank of England blinked under the threat of inflation?
The Bank of England (BoE) seems to be getting ready for Halloween early. Governor Andrew Bailey decided to give investors quite the fright last Sunday, confirming it may indeed raise interest rates soon. Markets reacted quickly, pricing in a rate hike for December and more to come in the first few months of next year. Implied market expectations put UK interest rates at 1.25% by the end of 2022, well above the current 0.1%, and the highest level in well over a decade. This all comes only a few months after the BoE put markets and financial institutions on notice for the possibility of negative interest rates. According to Bailey, the BoE “will have to act” against spiking inflation – a phrase which amounts to a policy announcement by central banker standards. Prices are rising rapidly in the UK, causing a hit to purchasing power and risking destabilisation of the economy. Clearly, the BoE feels swift action is needed to quell the danger that brings. As many commentators have argued, though, this reasoning seems a little off, given the current drivers of inflation are on the supply side. Wages certainly are rising in the UK but, as the BoE readily admits, the headline-grabbing figures touted for lorry drivers are far from representative. Average increases are below inflation (resulting in a loss of real purchasing power) and many workers have seen little to no pay rises. Britain’s current experience owes a lot to specific domestic factors too.

Central banks across the developed world are being much more cautious about tightening policy. In contrast to the BoE, the European Central Bank (ECB) and US Federal Reserve (Fed) have affirmed their commitment to keeping rates low and liquidity flowing. Accompanying this has been a belief that much of the current inflation pressure is ‘transitory’ and will normalise once the economic recovery matures and short-term issues are sorted out. In the 1970s (the last time a global supply shock sent prices higher while growth dwindled), raising interest rates was the norm – the rationale being that prices needed to be stabilised and inflationary behavioural tendencies needed to be quashed, even at the cost of growth. This is the thinking the BoE seems to share now, even while other central bankers take a different path. Last year, the Fed changed its policy framework to prioritise employment more heavily – effectively taking a structurally more dovish position. This came from a recognition that the old framework was not conducive to growth, and was likely inspired by the experience of the last decade. Since the Global Financial Crisis, central banks have persistently kept policy extremely loose but, despite long-term falls in unemployment, growth and inflation remained stubbornly low. Whether central bankers will stick to that promise is another matter. Already the BoE has blinked in the face of global inflation; now we wait to see if others do the same.

China’s problems are of its own making
China’s post-pandemic recovery is not going as planned. Last year, the world’s second-largest economy seemed to get a head-start on global growth after containing COVID much more effectively than the rest of the world, while also loosening fiscal and monetary policy. However, the People’s Bank of China has been the only major central bank to tighten policy over the course of the pandemic. Meanwhile, Xi Jinping has used the global crisis to crack down on everything from corporate leverage to ‘effeminate’ celebrities – moves which have constrained growth. To make matters worse, recent power shortages have put Xi’s target of ‘common prosperity’ at serious risk.

The crisis surrounding property giant Evergrande is emblematic of Beijing’s crackdown. Evergrande has more debt than any other property developer in the world, and its inability to meet bond yield payments on time has caused share prices to plummet. There have been huge concerns over the risk of domestic or global contagion should the company go under. But Evergrande’s slow-motion collapse is looking increasingly like a controlled demolition, even if the company bought itself some time by finding the $83.5 million necessary to stave off default on its latest overdue debt repayment. The pain has already spread to other parts of the property sector. Yields on dollar-denominated bonds for Chinese issuers soared after Evergrande’s first missed payment. Chinese developers now face their highest borrowing costs in more than a decade, and two other real estate groups have defaulted on a combined $425 million worth of bonds.

So far though, it seems China’s leadership seems content to let Evergrande become a cautionary tale about corporate excess. The property sector has been one of the main sources of China’s decade-long credit binge, and authorities clearly intend to use the opportunity to squeeze out speculative practices and confirm the caveat emptor principle in their financial markets by making an example of Evergrande. While officials will almost certainly not allow a Lehman-style collapse, their response has effectively endorsed the revaluation of the property sector. That will slow demand right across the economy and put a dampener on growth, as has already become apparent after the release of GDP growth figures for the third quarter. While a rate of 4.9% year-on-year is enviable, it is still the lowest for two decades. And, given how important Chinese growth is for the global economy (China has contributed more than America’s share of incremental global growth every year since 2001) this is a concern ahead of what could be a difficult winter. Not only are COVID cases rising, and restrictions being reimposed, but a massive fuel shortage has also left swathes of the country without energy. 70% of China’s electricity comes from coal, which has been in tight supply, causing prices to soar. Rising costs have made it impossible for many coal plants to turn a profit due to strict price caps. Beijing has eased these controls recently, and ordered producers to keep the lights on, but officials said this week they would take “specific measures to intervene” if prices kept rising.

The energy crisis is inspired by global events, but in many ways is also a problem of Beijing’s own making – chronic underinvestment has coincided with the closing of coal mines and power plants to meet environmental commitments. The recent spat with Australia over coal imports was a masterclass in self-sabotage. The end-result is one of the world’s most important economies becoming a source of both tightening supply and slowing demand. That is a recipe for the dreaded ‘stagflation’ – a prolonged period of high inflation and low growth – that keeps investors awake at night. Markets seem unfazed by China’s myriad difficulties for now, but that could quickly change – especially if investors’ other sources of optimism fade. Beijing’s problems are of its own making, but they are the world’s problems, nonetheless.