Monday Digest

Posted 29 November 2021

Overview: New COVID strain casts a long shadow into December
Last week offered plenty to be thankful – and fearful – about. In Europe, the COVID case surge was surpassed by fears of a new “variant of significant concern” emanating from South Africa. Over the weekend, new travel restrictions and tougher quarantine measures were imposed as countries across the world acted to delay the risk of transmission. US markets hit new highs just before the holiday, but the Black Friday mood darkened as details of the ‘Omicron’ variant unfolded, and investors sold out of pandemic-exposed sectors – travel and leisure were especially hard hit. Almost all market moves seemed in line with an anticipation of a significant hit to global growth. Government bond values rose, although corporate bonds were less in favour because of credit risk concerns; oil, metal and equity markets retrenched.

However, there was good news to digest last week too. US weekly data on unemployment showed the lowest (single week) number of initial claims since 1968. The labour market has shifted into an even higher gear. Employment globally is strong, corporate confidence about sales is very positive, while there are signs that supply chain issues are easing up. There may not be enough truck drivers, but the container ships are moving more easily. Meanwhile, the European Central Bank (ECB) has followed the Fed’s earlier playbook in indicating a change to bond buying sometime in the future, but not for now. The ECB has a fixed envelope related to pandemic buying: the Pandemic Emergency Purchase Programme (PEPP) which is widely expected to be wound down. However, the Asset Purchase Programme (APP) already in place before the pandemic is expected to be increased to €40 billion, to ensure tapering is smoother.

At present, even a slight flex of the major central banks’ hand may spook markets. Perhaps we are already seeing that in the prices of the more speculative assets. Aside from the US mega-caps, equity prices have mostly been marking time. And, after the Q3 earnings season, US equity analysts have become less positive, with downgrades outnumbering upgrades for the first time since the start of the pandemic recovery rally. Thus, the slow-moving policy tempo may coincide with faster-moving virus news, leading to increased volatility. With markets still only just off their highs, there are plenty of profits in the bag for this year, and a big temptation to book it before trading volumes get too low.

Germany’s traffic light coalition starts revving up
After two months of negotiations, Germany’s traffic light coalition government is set to go. Last Wednesday, Chancellor-in-waiting Olaf Scholz announced that agreement had been reached between his own Social Democratic Party (SPD), the Greens and the Free Democratic Party (FDP). It will be Germany’s first three-way coalition since the 1950s, and will see Scholz succeed Europe’s foremost political stalwart Angela Merkel next month.

Scholz has promised a “decade of investment” under the new government that would bring “the biggest industrial modernisation of Germany in more than 100 years”. Climate change is top of the long-term agenda, with leaders pledging to make Europe’s largest economy coal-free by 2030 – eight years earlier than planned – and to have 80% of the country’s electricity renewably generated by the same time. The new coalition has also resolved to be more assertive when dealing with Russia and China. Meanwhile, European neighbours may also hope the new regime will allow for more wiggle room on budgetary questions, especially as the European Stability and Growth Pact, which stipulates the stability of deficits and public debt, is being renegotiated. Even so, the number one priority is addressing Germany’s worsening COVID crisis. According to Bild, coalition leaders would prefer to wait and see if tighter COVID restrictions have had an impact on transmission rates. But further restrictions are possible, and the threat is noticeably weighing down economic sentiment. The news of a new – and potentially more aggressive – South African mutation could potentially add another dimension.

Arguably the biggest stumbling block for the coalition is that the fiscally hawkish FDP have been given control of the finance ministry. FDP politicians could well frustrate their coalition partners when it comes to spending decisions, resulting in confrontation down the line. The irony of the situation is that – judging from bond markets – there has never been a better time to loosen fiscal policy. The green transition needs capital investment, and the pandemic has prompted governments across Europe and the world to loosen budgetary constraints. Meanwhile, yields on ten-year German government bonds are in negative territory. With investors willing to pay Berlin to take their money, no major economy has as much room for fiscal expansion as Germany. But fiscal prudence is a powerful force in German politics – we should not be surprised if it scuppers significant spending again.

That said, both the tone and the content of negotiations are encouraging so far. Coalition deals can take months to strike and – given the political chasm between some of the members – one might have expected bitter and drawn-out talks. Instead, many potentially thorny issues have been settled quickly, and politicians have presented a coherent and consistent vision of government – even on contentious points like China’s human rights record. Throughout, Germany’s new leaders have appeared more pragmatic than idealistic. That is a good sign, as is the aforementioned fiscal headroom. Many voters will undoubtedly be disappointed with whatever compromise comes. But with four years until the next election, leaders might consider that a risk worth taking.

Japan makes another bid for economic blast-off
Japan has had low inflation for a long time. As a consequence, Japan’s purchasing power relative to countries with historically higher inflation – such as the US – has increased. All else being equal, this would suggest the yen should climb in value against countries with higher inflation. But we have seen the opposite. Against the yen, the dollar has been trending consistently upward throughout the year. At the time of writing, $1 will buy you just over 115JPY. That is the most expensive the dollar has been (or, conversely, the cheapest the yen has been) since 2017. That is quite some cheapening for Japan’s currency, with not much to explain why.

The simplest reason would be that investors think the return on Japanese assets will be lower than elsewhere – most likely due to lower economic growth. When comparing the country against similar major economies in absolute terms, that seems like a fair assessment. Which begs the question:  are Japan’s prospects dim enough to vindicate such cheap valuations? Here the answer is much less clear. Due to well-documented demographic problems, dated infrastructure and stubbornly high savings rates, Japan has a history of disappointing economic growth. But recently, we have seen encouraging news. Last  week, new Prime Minister Fumio Kishida announced a fiscal stimulus package worth 56 trillion yen ($490 billion) – a record amount part-funded by a wave of new bond issuance. The package includes everything from COVID support and climate change initiatives to technology and defence.

Kishida has promised to raise the proportion of GDP spent on defence from 1% to 2%. It may sound counterintuitive, but defence spending can have a big knock-on effect on growth prospects. Historically, military spending has been one of the biggest contributors to overall research and development, particularly in technology. But before we get ahead of ourselves, we should remember the similar excitement over former Prime Minister Shinzo Abe’s so-called ‘three arrows’ – which promised fiscal largesse, monetary injections and structural reform, but underwhelmed on all counts. Critics have already pointed out Kishida’s figure flatters to deceive in terms of new spending. Longer-term problems persist of course, such as an aging population increasingly in need of costly care and a corporate preference for saving. The latter is itself a target of reform by the new government – and early signs are encouraging – but it remains to be seen how effective reforms will be. But while first-round effects from government stimulus are positive on their own, the potential second-round effects on productivity and investment could prove a big source of optimism. If it also prompts capital flows back toward Japan, we could see a cascade effect as markets revise their valuations of Japanese assets. That is a big ‘if’, but it is one we will be keeping a close eye on.

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