Monday digest

Posted 8 November 2021

Overview: no tantrums over this taper
October’s positivity across global stock markets spilled over into the first week of November, with the notable exception of China, which appears to be increasingly isolating itself from the rest of the world. Not only was its leader absent from COP26, but it is also choosing to let international bondholders bear the brunt of the ongoing financial woes of its property developers. No wonder then, that Chinese stocks have fallen thoroughly out of favour with investors this year.

COP26 might have been the main topic of discussion last week, but it was once again the deliberations of central banks that captured the attention of investors. While corporate earnings reports have lifted the mood over the past week, there remained a lingering concern that central banks were about to make their first post-pandemic policy mistake. Faced with stubborn inflationary pressures, it was feared some would blink and break from their stated course of keeping rates and monetary conditions very loose for longer. In particular, the Bank of England (BoE) had signalled since the summer that it was likely to raise rates to prevent inflationary tendencies taking hold. In the US, the Federal Reserve (Fed) had similarly signalled it would start to reduce monthly liquidity injections by tapering them back down to zero by the summer of next year. In the end, it was the Fed that delivered on its guidance, and it was the BoE that blinked, albeit by keeping rates where they were.

Yet the message from both the Fed and BoE was convincingly similar: growth is expected to continue while inflation will very much remain on the radar and pressures should ease next year, once pandemic-induced supply shortages are overcome. It may seem that central banks are no longer acting in a concerted fashion, but that is not how it was perceived by the markets. Instead of a renewed taper tantrum, markets remained very calm and indeed took the actions of both central banks (and accompanying language) as confirmation of the previously more positive growth outlook.

Investors still have the second half of third-quarter corporate earnings (profits) reports to digest, but based on the results so far, further reassurance could be coming. That’s not to say investors should be complacent, however, as the prospect of rising yields or a COVID driven declining economic outlook may still create tense moments that need closely watching as we head towards year-end.

COP26: good COP, bad COP
With a week of deliberations and announcements still to come, politicians have already made plenty of promises to aid the urgently needed global green transition. Policymakers have set or re-emphasised targets to phase out fossil fuels – particularly coal – as well as introducing mechanisms to prevent those who might bend the rules. The International Financial Reporting Standards Foundation’s (IFRS) newly announced board on so-called ‘greenwashing’ appears significant. As the body responsible for international accounting standards, the IFRS is aware of the tendency of private companies to shift or hide polluting practices. The International Sustainability Standards Board ISSB will consolidate existing authorities into a single set of standards “to meet investors’ information needs”.

Politicians, corporations and investors have long made the point that the regulation that defines financial frameworks must change in a concerted manner if global capital is to be mobilised to get behind the green transition. A lack of clear rules on what counts as ‘green practices’ is a major roadblock, disincentivising green investment and stalling long-term planning. Giving more consistent guidelines will help the world put its money where its leaders’ mouths are. Of course, another question yet again is which countries and corporates subscribe to those standards.

On that point, one of the biggest headlines so far came from the Glasgow Financial Alliance for Net Zero (GFANZ). GFANZ is an alliance of private companies and net-zero initiatives headed by former BoE Governor Mark Carney, with the aim of making the investment world’s assets greener. And this group does have quite the pile of assets. According to Carney, GFANZ has signed-up $130 trillion of private capital to commit to reaching net-zero emissions by 2050. That is more than the estimated market capitalisation of all the world’s stock markets combined, and six times larger than US GDP.

While the sheer size of the figure succeeds in grabbing attention, it is difficult not to be a little sceptical. Signatories are committed to setting emission reduction targets every five years, starting in 2030 and lasting until net-zero is (hopefully) achieved in 2050. In theory, that should mean the $130 trillion represents the current worth of all the assets that will be carbon-neutral in 30 years. GFANZ says this could deliver $100 trillion to help the fight against climate change in that time. But it is hard to tell what the underlying makeup of signatories’ assets is. GFANZ members have set net-zero targets for just 35% of their assets so far. And, given that banks and asset managers make up most of the group, some of the money is likely being counted several times over – through lending chains or securitisation. But as misleading as the headline figure may be, Carney and GFANZ have succeeded in terms of creating positive momentum and mobilising capital for climate change. These efforts are likely to be bolstered – in the eyes of capital markets at least – by the recent appointment of Michael Bloomberg as GFANZ’s co-chair. What’s more, when you consider the ISSB’s soon-to-be unified guidelines, GFANZ should have more power to effect change in the world’s financial system.

Central bank bait-and-switch leaves markets
If the intention of the BoE was to catch markets off-guard, the plan worked perfectly. On Thursday, after announcing that interest rates would remain on hold, sterling fell 1.2% and short-term government bonds rallied, as investor expectations of tighter conditions in the UK were proven wrong. Those expectations were based on Governor Andrew Bailey’s warnings that the BoE “will have to act” to restrain the inflation spike. The decision not to act seemed even more perplexing when the BoE’s own inflation forecast has risen to its highest level in a decade.

These days, good communication has become as important a part of central banking as interest rates themselves. Capital markets do not like a ‘bait-and-switch’ at the best of times, and this is especially true for monetary policy. For bond markets and the wider economy to run smoothly, reliable expectations of inflation and background financial conditions are vital. As such, the MPC’s feint was not well received. That said, while markets were certainly expecting a rate hike, they were not particularly happy about it.

When Bailey (seemingly) revealed his intention to raise interest rates last month, we noted this could prove a policy error that might choke off the recovery prematurely. The difficulty facing central bankers, though, is how long to keep emergency support going. The global economy is still ultimately in a transition phase, and the problem for monetary policymakers is figuring out what it is transitioning to. Fed Chair Jay Powell announced last week it would begin unwinding its $120 billion a week bond purchasing programme. This is one of the biggest changes to Fed policy since the onset of the pandemic, and the  onset of Fed tightening – even the mention of it – has caused market havoc in the past, such as the so-called ‘taper tantrum’ of 2013. But having the taper without the tantrum is not quite a sign of markets growing up. Rather, reaction was muted because investors seemingly have confidence in Powell’s dovish approach.

On interest rates, the Fed is even more cautious. Previous Fed chairs would almost certainly be in rate hike territory by now. But since the change to the Fed’s structural framework last year, Powell insists officials will stay the course until the economy reaches full employment and an average inflation level of 2% over time. This means the Fed can overshoot the 2% level after years of undershooting it. Ultimately, though, the Fed faces the same problem as the BoE. Support cannot go on forever, but how and when it should be taken away is mightily tricky. The BoE has been somewhat more unorthodox in hinting at an early rate hike – but that is perhaps to do with the UK’s lack of inflation undershooting in recent years. Regardless, the world’s central banks need to take the patient out of intensive care sooner rather than later. For markets’ sake, as observed in the US this week, we hope we at least get fair warning.

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