Posted 30 May 2022
Outlook: as recession talk subsides, inflation pressures increase
As we head towards the final days of May, markets appear to be calming down. Stock markets just enjoyed a positive week where credit spreads – the proverbial canary in the coalmine ahead of recessions – came down sharply. So, what has caused the change in sentiment? Possibly it is due to a slight easing of the three main headwinds: central bank policy tightening, the cost-of-living and energy crisis, and China’s economic weakness.
On the central bank tightening side, investors may have been relieved by inferences from the most recent meeting of the Fed’s (US Federal Reserve) Open Market Committee. While the Fed remains resolute in stating the current primacy of fighting inflation, the meeting minutes raise concerns about financial stability. The interpretation is that these concerns will bring hawkish monetary policy back to neutral. This may be jumping the gun, however. Despite turbulence in the credit and equity markets, bank lending remains strong, and the total of US job vacancies still exceeds the current workforce.
Turning to the cost-of-living headwind from inflation, even after the reduction of wage pressures from cooling labour markets, developed world inflation expectations are still hugely influenced by energy costs. For policymakers, this is a massive policy conundrum, as well as a challenge from their voter base, and this is probably most apparent here in the UK. Of course, the UK is not the only country feeling this pressure, and if Europe cannot reduce its fossil fuel demand and displace Russian energy from its supply, we need new sources of production. For the central banks, they need signals that overall demand has moved into line with supply before they can think their inflation fighting is done. Energy demand is a big part of that signal.
The third headwind facing markets this year has been China’s difficulties in its attempts to deflate its property bubble while still grappling with COVID and widespread lockdowns. It’s been notable that China’s financial conditions have been easing sharply over the past two weeks. With the quite extreme governmental policy push, it is not surprising investors are sensing that China’s near-term outlook may finally be improving, and therefore the growth drag on the global economy may be diminishing. China’s recent weakness has probably helped in lessening global inflation pressures. Industrial metals have fallen back somewhat, and it seemed energy prices were moving the same way. However, oil prices were heading back towards recent highs last week.
Markets have taken comfort of late that economies have been cooling. Should China succeed in engineering a rebound, it may mean more production capacity for finished goods, thereby reducing price pressures from last year’s supply chain issues. It may, however, mean rising energy demand and the inadvertent return of energy and resource inflation pressures on the rest of the world. This week, markets may have glimpsed the “Goldilocks” scenario – not too hot and not too cold – but nobody will be sure until the oil smoke drifts away.
Labour market dynamics cause consternation
Labour market dynamics have been strange over the last two years – with a shrinking of the workforce making it difficult for central bankers to properly assess their economies. Despite the lowest unemployment rate in 50 years, the UK’s employment rate is still well below pre-pandemic levels. Bank of England (BoE) Governor Andrew Bailey blames this for Britain’s stubbornly high inflation rate. Most worryingly for the BoE, this problem seems to be UK-specific – Britain now has the slowest growing employment rate out of the G7. The reasons for this seem to be a combination of chronic sickness and a lack of access for foreign workers. Neither of these issues can be solved quickly, which makes them big concerns for the BoE.
In the US, the distortions of the labour market have started to ease but are not yet completely gone. There are certainly fewer people employed now than at the onset of the pandemic, but there are signs that the gap between labour demand (companies looking for labour) and labour supply (number of people willing to work) is stabilising. Fed Chair Jay Powell will be pleased to see jobs data coming off the boil, even if it is too early to declare victory over an overheating labour market. Things are moving in the right direction, but the gap between jobs and workers is still too high, meaning another round of wage inflation is possible. Powell will need confirmation that the jobs market is getting back to normal. Further improvement in the participation rate would be a good sign, ensuring the business cycle can continue at a steady pace.
Still, to bring inflation back to sustainable levels, more available workers would be the most welcome solution. The problem is that participation is much harder for a central bank to control. Monetary policy affects unemployment and inflation by altering the money supply and shifting incentives. But if the issue is instead one of health or immigration – a lack of able workers – there is not much that monetary policy can do. This is the issue central bankers are grappling with. Signs of improvement should be enough to ease their hawkish policies, but without those they may be forced to tighten more aggressively. We should therefore expect markets to respond positively to more signs of labour market cooling.
Is self-certification the next ‘greenwashing’ scandal?
The debate around environmental, social and governance (ESG) investing flared last week, following controversial comments about climate change and its impact on the financial system made by Stuart Kirk, HSBC’s head of responsible investing. But Kirk’s comments were not the only source of ESG controversy this month. In the latest rebalancing of the S&P 500 ESG index, electric carmaker Tesla was excluded, while oil giant ExxonMobil was given the all-clear. This was enough for Tesla CEO Elon Musk to tweet that “ESG is a scam… weaponized by phony social justice warriors”.
S&P insisted it followed the usual rules and procedures of the index, with Tesla’s lack of a low-carbon strategy proving an issue. There have also been high-profile claims of racial discrimination and poor working conditions at factories, which pushed Tesla into the bottom quarter of the S&P’s ratings for the automotive industry. Nevertheless, the fact that Tesla – a leading brand in low-carbon transport – was knocked off the index while Exxon remains inevitably raises eyebrows. It highlights ESG is not all about the ‘E’, as is sometimes assumed. Environmental criteria are certainly important to ratings providers, but other considerations can be equally important. The Tesla controversy also shows how inconsistent different ESG labels can be. Data on sales and profits are standardised, and there are clear regulations on what and how companies must report. This is not yet so for ESG metrics, where ratings agencies like S&P or MSCI must come up with their own criteria and data points. This lack of consistency has been a long-term challenge for investors, so is understandably now coming under scrutiny.
The investment industry has grown familiar with the term ‘greenwashing’, where companies artificially talk up ESG principals, claim involvement in the green transition, or boast of a low carbon footprint. Doing ‘good’ – and making money while you do it – is attractive, but without a consistent set of guidelines, ESG is left up to the interpretation of companies or ratings agencies, which will inevitably differ and be influenced to varying degrees by commercial conflicts of interest. Making such criteria transparent and consistent are necessary first steps, but if companies and index providers are left to regulate themselves – and self-certify achievements and progress – the disconnect will continue.
This is not to say there is no value in S&P’s or MSCI’s ESG criteria. They can often overlap with what we as investment managers want to achieve. Moreover, the data collected on different companies is essential in terms of understanding each company’s activities and level of engagement. But their interpretation is not the end of the story. Regulators need to provide clear rules for consistency, and ultimately these issues need to be settled in conversation with investors. ESG guidelines are the starting point, but there is a long way still to go.