Posted 15 November 2021
Overview: Central banks struggle with messaging
After five weeks of markets inching higher, risk assets slowed as investors – once again – became concerned about rising bond yields on the back of rising inflation. This came despite economic data, for once, suggesting the worst of supply chain constraints may be over. If this market action became a trend then this would be bad news for both bond as well as equity investors. We suspect market participants are currently struggling to make sense of the various factors that define this very unusual type of recovery, post a pandemic lockdown.
Normally, overheating demand rather than struggling supply causes inflationary pressures, but with economies so radically switched off and on again, the resulting upheaval is taking longer to settle. Central banks are mandated to prevent inflation, whatever its cause, or risk losing their credibility. As a result, and after US inflation figures jumping above 6%, the growing concern is that they will feel forced to tighten monetary conditions before the economy is ready for such a move and thereby prematurely end an economic cycle that is just getting going. That would indeed be bad for growth.
These concerns seem well founded. Central banks have already signalled an intention to reduce monetary support, but the pertinent point is that markets are unable to differentiate between ending financial support of the pandemic void and outright monetary tightening. It’s accepted that extraordinary quantitative easing is no longer required, so it seems right to taper ongoing liquidity injections, however, rate rises would definitely go beyond monetary normalisation.
Slowing economic growth combined with the prospect of premature monetary tightening has led to bond markets pricing in much lower medium term growth expectations. However, economic news pointing towards peak supply disruption being behind, has reinforced our assessment that this cycle is well entrenched, and more likely to surprise, with growth rates looking up rather than down.
Turning to COP26, we record a half-way house of progress. Encouraging; the surprise announcement of a bi-lateral agreement between the two biggest emitters on the planet, the US and China. Disappointing; the compromise on fossil fuels and the lack of detail in ‘how’. However, China slowly emerging from its self-isolation is a positive for its contribution to global growth, which most (us included) had as ‘negligible’ for this cycle.
There is also welcome positive momentum toward capital markets fighting climate change. However, the impression that its global investors’ responsibility to solve climate change, is misunderstanding what capital markets are. To harness the power of markets effectively, economic frameworks for addressing climate change must offer commercial opportunity. This prerequisite is within the gift of global societies and the politicians they elect. Capital markets can be very efficient in furthering collective aims of society, but not without the political executive of societies.
The bad kind of Inflation
We are in the middle of the biggest inflation bout in years as post lockdown supply issues are sending prices skyward yet monetary policy seems as loose as it has ever been.
The US Fed has been slowly implementing its signaled tapering of QE whilst reassuring that rate rises are far away and the Bank of England also avoided its seemingly certain hike the week before last. Inflation is running ahead, but interest rates are not following it.
If loose monetary policy is positive for markets, tightening policy is a downer as the ‘taper tantrum’ of 2013 showed. The fact that real yields for US Treasury bonds fell sharply last week, shows markets might believe the risk of central bank tightening before the time, choking growth next year.
A flattening US treasury curve indicates markets have dampened long-term growth expectations. This implies a subdued economic view: rising inflation without structurally higher longer term growth.
Investors appear to think inflation next year will be the bad kind – rising without growth. This is difficult for central banks, they need to support growth but also convince markets that support will not destabilise prices.
The challenge is to convince markets not to assume tapering heralds a premature policy shift to outright monetary tightening, but it is hard to tell which policies are emergency measures and which are part of the new normal.
This muddle is bound to cause issues. One being the potential for a small-scale taper tantrum that threatens wider capital markets’ support for the recovery. Avoiding a taper needs real yields to remain relatively stable and avoid a general re-pricing of risk assets. Maintaining low real yields is a top priority for the Fed – allowing growth to feed back into a normalising economy.
Eventually, though, this has to change. Interest rates and real yields must creep up as an economic cycle matures. When is up for debate, but already the fears around this prospect have changed. The Fed would not have allowed real yields to rise substantially a year ago.
We think the week’s bond moves could be a false signa l- ‘one week does not make a trend change’ and we will observe closely how the Fed copes and where yield levels go over the coming weeks.
China less isolated?
The pandemic kick-started China into a period of international isolation and communist crackdowns. After decades of integration and opening up, China began closing its gates, pursuing self-reliance and a decoupling from the US-led world economy.
Until last week. At COP26, China and America announced a rare joint declaration of environmental cooperation and Chinese President Xi warned Asia-Pacific leaders of the danger of international division lamenting the attempts to “form small circles on geopolitical grounds” and the “Cold War” mentality of US-led partnerships.
These are small steps and national self-reliance is a central tenet of the communist party, a target accelerated by the supply-chain worries throughout the pandemic. This is deeply connected to the Communist party’s desire to maintain absolute control and specifically Xi’s desire to centralise and consolidate power.
What should investors make of this week’s apparent shift?
We suspect that Beijing’s mixed signals are due to complicated and conflicting factors. While self-reliance is certainly a facet of the party’s vision, it has to be seen in the context of other aims: Long-term economic stability, reducing inequality and corruption, developing into a greener and more advanced nation and Xi’s personal consolidation of power. Some of these aims motivate isolation and crackdowns, others motivate openness and cooperation. For any given party policy, it is often hard to say which aim is the primary one.
Beijing’s financial deleveraging efforts are a good example. For years, the government has fought against China’s shadow banking sector and sought to discourage excessive debt or speculation. This has included keeping monetary policy relatively tight throughout the pandemic, with the aim of achieving long-term financial stability. However, if credit problems spiral – as they threaten to now with Evergrande – Beijing’s efforts will be undermined. This has led to sporadic episodes of stimulus, as well as trying to contain the Evergrande threat, though we believe Chinese authorities will have to become more forthcoming to contain the wider fall-out from the property sector.
For Evergrande in particular, matters are complicated by looking at the government’s competing goals: Promoting equality, improving the environment and preventing private actors from gaining too much power. A few months ago, there were concerns that Beijing’s interventionism was making China ‘uninvestable’, but the issue is more about a re-pricing of risk than avoiding China altogether. Xi still wants a vibrant private sector; he just does not want it more than his other goals.
We suspect that shoring up economic confidence will remain a priority. Crackdowns and crisis in the property sector have sent corporate borrowing costs substantially higher and supply issues have caused severe disruption across the country. With a difficult winter ahead, officials will be deeply concerned by the threat of a nationwide downturn. An easing of financial or regulatory conditions would help to boost domestic confidence and attract international capital.
A rapprochement with the US – and engagement with the wider world – could well be another part of this softening. If it works to lower investors’ perceptions of risk in China, and that is a big if, it could mean we may be passed the low-point for Chinese assets.
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested. All calls to and from our landlines and mobiles are recorded to meet regulatory requirements.