Tuesday digest

Posted 2 April 2024

Everyone is an optimist now

The first quarter of 2024 was another strong one for stocks. That’s a pleasant surprise, given the massive rally that came before. The MSCI World Index has only had one down week since the end of October, and has risen 25% in dollar terms in that time. UK stocks haven’t rallied as much, but the FTSE 100 is now within touching distance of 8,000 points. Flutter Entertainment’s recent US listing switch shows the unfortunate decline in the UK’s worldwide status, but London will keep being a hub for global capital flows even if trades are executed elsewhere.

Corporate bonds have also improved, even for riskier borrowers. Credit spreads have come down even though government yields have gone up slightly. That means overall borrowing costs for companies are only a little higher, on a net basis, than pre-rate rises. Rates are higher but growth is stronger and is expected to remain strong – so firms can afford it.

Volatility has come right down too, with the VIX index at levels not seen since 2019. But expected volatility – as measured by the MOVE index – remains high, suggesting investors are worried yields could spike again. If expectations come down to meet reality, there is still greater risk appetite to be awakened – good news for equities.

That might be fuel for another bullish quarter, but positivity is already priced in. While growth expectations and private sector balance sheets are generally better than pre-pandemic, public sector borrowing is a concern. We saw what this can do during Liz Truss’s not-so-mini budget, and BlackRock’s Larry Fink is warning that the US might be in for something similar. Expect the presidential election to throw a few fiscal bombshells at bond markets.

Another risk is that inflation could come back, with Brent Crude oil prices heading back to $90 per barrel. This could be nothing if oil supplies even out, but it could also spook markets in the short-term. Markets will now look to see if Q1’s corporate earnings results live up to the growth hype.

Inflation volatility creating inflation?

Central banks are now hinting that inflation has been beaten, without causing deep recessions. Commentators call it ‘immaculate disinflation’ and markets need no convincing: year-to-date stock returns are strong in the US, Europe and UK. But there are niggling signs of sticky inflation, particularly in the US and in the global services sector.

A recent paper from Evi Pappa of Carlos III University, Madrid, argues prices have not budged because of inflation volatility. We know that firms often raise prices when inflation is high – the dreaded wage-price spiral – but her research suggests this isn’t just when inflation is high, but when it is rapidly changing. That means we can still see inflationary behaviour even when inflation is coming down.

Intuitively, this is because it creates a feeling of price instability. Firms might want to keep prices high to protect against volatile costs, and consumers might be more willing to accept a higher price if they can’t work out what the fair price should be. Supermarkets regularly exploit this by putting ‘bargain deal’ labels on products to disguise underlying price rises.

Uncertainty is the key element – and we have had plenty of uncertainty in the last few years. This might be why central bankers were preaching ‘higher for longer’ for so long, against market expectations. Pappa’s research suggests that when inflation is volatile, rates need to stay high to discourage companies from building price buffers.

But we think the problem with this story is that it focuses entirely on the supply-side effects. Uncertainty also decreases demand by making consumers less willing to consume – as we have seen in the UK, Europe and China. It is hard to say whether the supply or demand effects will be stronger going forward. The dovish Fed seems to think demand, while the cautious ECB seems to think supply.

Carbon border adjustment

The UK is running a consultation on its carbon border adjustment mechanism (CBAM), to be rolled out in 2027. It follows the EU’s CBAM introduction last year, designed to level the playing field for emissions costs between domestic and foreign goods – a key pillar of net-zero targets.

CBAM is designed to fix a problem with the Emissions Trading System (ETS), a ‘cap-and-trade’ policy where firms trade carbon credits (which allow them to emit) on the open market. The UK and EU’s ETS systems are broadly the same, designed to let the ‘invisible hand’ of the market allocate emission rights to companies that most need them, while giving policymakers the power to control overall emissions.

Unfortunately, ETS leads to ‘carbon leakage’ – emissions from Europe or the UK just being replaced by emissions from somewhere with less stringent regulations. Not only does this negate the environmental impact of ETS, it means that foreign producers – like US companies under no ‘cap-and-trade’ scheme – have a price advantage over domestic producers.

CBAM is supposed to fix this by putting a “fair price on the carbon emitted” by companies selling into Europe. Importers buy CBAM certificates to match the emissions that went into their production (all of which must be thoroughly reported), and the price of certificates is set by the price of carbon credits. The EU’s CBAM is currently in a “transition phase” where firms have to report but not pay, which officials call “a learning period for all stakeholders”.

One of the biggest issues will likely be the sole focus on imports, leaving open the possibility that British and European exports might have a price disadvantage in global markets. The problem, as always with climate policy, is lack of international cohesion. We think CBAM will have a positive impact on reducing emissions, but could be another disadvantage for Europeans. We will watch the transition closely.