Monday digest

Posted 1 November 2021

Overview: Bond markets give central bankers a telling off
Capital markets enjoyed another good week, although with one notable difference – this time bond investors were allowed to join in. Just as energy prices started stabilising, corporate earnings results proved less supportive than in the previous week, while macroeconomic data is still documenting the slowdown of the global economy. Although the slight deterioration of growth expectations for next year was not enough to rob equity markets of medium-term support, it was enough to move bond markets.

While central banks keep repeating their mantra of lower rates for longer, bond markets are telling them in no uncertain terms to wake up and smell the coffee – and of inflation eating away even more at their meagre-to-negative yields. The unwinding of pandemic support programmes constitutes a formidable challenge to governments around the world, because unless the private sector picks up the slack at the same rate as governments remove the support, it becomes a drag on the combined demand that drives the economy. The biggest fiscal support expectations were always centred on the US, where at least there appeared to be some light at the end of the tunnel as political negotiations progressed. But with monetary tightening taking place – courtesy of the bond markets pre-empting what central banks are loath to do – the fiscal easing that would counterbalance this (and also put global economic growth onto a more even keel) is not as forthcoming as expected and telegraphed earlier in the year.

None of last week’s events are in any way earth-shattering or deeply worrying for investors. They simply suggest that the economic upside (and therefore the investment upside) was this week seen as more limited than previously anticipated. There are plenty of voices reminding us this is all still part of the ‘climbing the wall of worries’ narrative discussed here before. We would largely agree, but as with the threat of climate change counter action, time is of the essence if we want to experience a brighter future than the ten years behind us.

Autumn Budget: Sunak bets big while playing a weak hand
In his Autumn Budget last week, Chancellor Rishi Sunak reminded MPs that he is a small-state conservative at heart, with a desire to lower taxes and stop the inexorable growth of public spending. But if his mission is to trim the Treasury’s waistline, the diet only starts tomorrow; today is the feast. Because in the same speech where Sunak talked up his fiscal conservatism, he announced the highest levels of public spending since the 1970s (except for the time after the pandemic), coupled with Britain’s highest taxes since the 1950s. Total government spending will account for 41.6% of UK GDP by the 2026-27 fiscal year. That is below the 45% we will see in 2021-22, and significantly below the 53.1% reached in the height of the pandemic. But while the Chancellor boasted these facts as a show of the government’s shrinking fiscal footprint, the result is, nevertheless, long-term tax and spend figures well above pre-pandemic levels.

The capital market response to the Budget proved interesting. Short-term bond yields in the UK were driven up – reflecting a boost to near-term growth expectations. But further out, bond yields have fallen, suggesting investors are either less confident about long-term growth prospects or expect the government having to tap capital markets less, or likely a combination of both. This has resulted in a flattening of the yield curve – the difference between yields of different bond maturities. A crucial element to this, well-noted by the Chancellor, is inflation. A plethora of global supply constraints have teamed up with domestic problems to deliver a sharp spike in prices. Inflation is expected to peak at 4.4% in the second quarter of 2022, well above the level forecasted back in March. The Office for Budget Responsibility (OBR) agrees with many economists that the inflation spike will be relatively short-lived, but there are nevertheless concerns elsewhere that elevated prices could persist.

The Bank of England (BoE) seems to share these concerns. At its latest meeting, officials strongly suggested they would raise interest rates by the end of the year to combat rising prices. An increase in public spending will only raise inflation expectations further in the short-term, giving the BoE more reason to act. But as we wrote last week, on growth, a tightening of monetary policy could have an offsetting impact to the government’s fiscal easing, hitting demand over the medium-term.

This is far from just a British problem. In the US, the Democratic Party is struggling to find a common voice on fiscal policy, despite President Biden announcing a new tax and spend framework last week. In Europe, the European Union (EU) growth and stability pact – which sets strict limits on how much nations are allowed to borrow – is suspended for 2022. This is a positive for supporting growth, but the rules will come back into force the following year – and what form they will take is not yet clear. If the first announcements of what should become Germany’s new government is anything to go by, we should not expect fiscal largesse – ongoing coalition negotiations have started with an agreement to constitutional debt limits. But according to estimates from the International Monetary Fund, the UK’s fiscal contraction is currently bigger than most – which is mostly a consequence of the largess of the past 18 months coming to an end as furlough, business support and various pandemic related health sector measures are ending. The Chancellor’s new Budget has somewhat helped this cliff-edge situation for the shorter term, but after that, a tightening of the belt still looms large.

COP26: Markets want the world’s leaders to take the lead
Without a crystal ball, it’s impossible to make any predictions of what progress will indeed be made at the 2021 United Nations Climate Change Conference, known as COP26, over the next couple of weeks, if any. We are not holding our breath for any big breakthroughs and announcements, but would very much like to see the current talk around creating more reliable investment frameworks converted into meaningful action and progress. Because when it comes to tackling climate change, every action has a reaction, creating losers as well as winners.

Carbon pricing is one such example where more than the ‘invisible hand’ of markets is required to find a solution. Carbon pricing programmes usually involve countries taxing polluters’ carbon emissions, or ‘cap and trade’ systems that effectively limit a company’s level of emissions before costs become prohibitive. International business groups are pushing for an international carbon price strategy to be unveiled at COP26, to prevent the bewildering patchwork collection of local policies they are struggling to contend with now. But getting a majority of countries to agree to some sort of carbon pricing framework with a  carbon price that is high enough looks like a tall order.

Another key theme that emerged last week was divestment.Last Tuesday,Europe’s biggest pension fund, ABP of the Netherlands, announced plans to divest €15 billion worth of fossil fuel assets by early 2023. That, along with several other big divestment announcements, brings the total assets under management committed to be switched out of fossil fuels by asset managers to a stunning £39 trillion in the next few years. Unsurprisingly, fossil fuel producers have spoken out against the hidden dangers of divestment. Coal producer Glencore argued the movement was counterproductive, as it would force them to dispose of their assets and place them in the hands of less responsible owners (‘brown-washing’). They have a point. After all, divestment just means gains are being pushed elsewhere and perhaps towards investors without CO2 reduction aims at all. Moreover, selling the stocks themselves doesn’t reduce the demand – or use – of fossil fuels. Instead, it’s likely to just make stocks more volatile, and therefore tradeable. Without government action, and policy on a global scale, that discourages the use of fossil fuels, there will always be a demand for ‘dirty fuels’ to be met by someone.

Climate change is a global problem that requires a truly global approach. The key point regarding COP26 is that big events like these can – and must – be used to create common frameworks. If we think green investment is still the missing piece of the puzzle, and we want the market to help solve this problem, they need clarity, transparency and the certainty that is so crucial for successful longer-term investments. At the same time, from an investment point of view, it’s important to recognise that climate change is not a sector-by-sector issue. The whole of the economy has to ‘green up’, while accepting the risk of stranded assets and that there will be losers as well as winners. So far, governments have shied away from the hard choices that climate action demands, without being honest about what a fully transitioned global economy would look like – for better or worse. We can’t keep having it both ways.

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