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Lacklustre. After a year of strong gains, global stock markets fell in September and confidence has remained lacklustre since, on growing investor fears over inflation. This is heightened because, by August, major stock market indices (notably the U.S market), together with core government bond markets, had both appeared priced for perfection. (Ie, investors were betting on a ‘Goldilocks’ scenario of strong global economic growth, with controlled inflation). Stocks and bonds had become very susceptible to any whiff of bad news, that would trigger profit-taking.
The sell-off in stock markets could equally have come from a market event (eg, a messy collapse of Evergrande in China), or from geopolitics (eg, a fresh wave of lockdowns around the world), such as the ‘pricing to perfection’ we had seen.
This is not to make light of troubling inflation data. Out goes the Goldilocks scenario and in comes a fear of stubborn supply-side inflation with reduced output due to shortages, with the added threat of tighter monetary policy from central banks that need to act against inflation in order to maintain credibility. In addition is a growing fear that wage rises, currently limited to certain sectors, become a more general feature of western economies, and so generate an additional driver of inflation: a wages/prices spiral. These new scenarios present difficult-to-predict outcomes for corporate earnings, economic growth and central bank policy. And for investors.
The major western central banks are all waiting to see how their labour markets respond to the unwinding in recent months of pandemic measures, such as enhanced welfare payments and furlough pay. Any sign of a wages/prices spiral emerging, on top of the existing supply-side inflation, must surely prompt central bank action given the increasing aggressive noises from central banks in recent weeks. If they sit still they will lose credibility.
Some economists believe that so long as public sector wages remain virtually on freeze, and trade unions weak, there is little risk of a return to the 1970s era of wage growth in key sectors leading to wage increases for all. Others are not so sanguine, noting the increase in starting salaries for Wall Street professionals – not a sector traditionally short of supply. In the U.K, higher wages are being presented by the government as a benefit of Brexit, and the tool by which companies are forced to invest and become more productive with the labour that they employ.
Of the developed economies, the Norwegian and New Zealand central banks have begun raising interest rates. The Fed, the ECB, and the Bank of England may start at the end of this year, if wage inflation persists. However, over time the supply-side problems tend to resolve themselves, and prices stabilise. It is important that central banks do not overreact to ‘sticky’ supply-side shocks to labour and goods markets through tightening monetary policy too fast, and so risking an economic downturn.
Interestingly, despite U.S inflation remaining doggedly over 5%, and the Fed warning both of imminent rate hikes and tapering of its asset purchase program, the 10 yr Treasury yield stands at 1.58%. Certainly, this is up over 20 basis points in recent weeks. But it remains below the April high of 1.73% when most economists believed inflation would be rolling over in late 2021. If Treasury prices still have signalling power (I believe they do), this suggests that bond investors suspect the Fed will over-react to current inflation concerns. A steep Treasury yield curve (ie, higher long term yields compared to short term yields) is associated with economic growth and inflation risk, the current rather flat curve implies weak growth and inflation in the long term.
A multitude of factors have contributed to the rally in oil and gas prices in recent months. Demand growth has been a factor, as the global recovery led to a surge in usage, particularly in Asia, and as governments increasingly discourage the use of coal on environmental grounds. However, supply issues have been the dominant theme. These include OPEC+ group of oil producers deciding against a rapid expansion of output to meet demand growth, which has contributed to Goldman Sachs speculating that $90 a barrel may be reached in the coming months.
Gas prices have been supported by low stockpiles in Europe, and by Gazprom of Russia making less available than was expected on the spot market. There is speculation that this is a tactic by the Kremlin to persuade Europe to start operating the Nordstream 2 gas pipeline, which is currently awaiting German (and other) regulatory approval. Nord Stream 2 (ie, Gazprom) must meet E.U ‘unbundling’ rules relating to the separate ownership of the gas pipeline, from its production and sale. It will be interesting to see how rigidly this rule will be applied if Europe has a cold winter, and Putin continues to limit gas supplies on the spot market.
In the meantime, energy stocks have been amongst the strongest on global stock markets, and have helped lift the bourses of Russia and Gulf countries while developed stock markets have weakened.
The greenback has also performed well in the current nervous environment. It has been supported by the prospect of Fed tightening of monetary policy, but also by its defensive characteristics. It remains the world’s reserve currency. It is likely to remain strong as long as weak economic data remains a problem.
The world’s most indebted property company, Evergrande of China, suspended its Hong Kong share listing last week. Meanwhile, speculation grew that Hopson Development -a mainland China, but Hong Kong-listed developer- would acquire Evergrande’s property management unit. Evergrande has missed two interest payment dates in recent weeks on dollar-denominated bonds. However, hedge funds and other speculative investors are said to be acquiring the debt, betting that the Chinese government will, eventually, restructure the company and make good the obligations in order to ensure stability in the country’s financial system. The company has around $20bn worth of outstanding dollar bonds, last week the March 2022 bond was trading at about $0.26 on the dollar.
We may see further autumn storms on global financial markets over the coming months, as the inflation and growth picture evolves. Or, we may see the Goldilocks scenario re-emerge and stock markets rally once again. But a ‘muddling through’ scenario is most likely. Central banks raise rates and taper asset purchase schemes just enough to reassure bond markets that they are alive to inflation worries while waiting for supply-side shocks to resolve themselves. Wages rise in a few sectors, but not in aggregate. The global economic recovery continues, but growth expectations for the next 18 months are revised downwards somewhat. Along with corporate earnings estimates.
Fortunately, investors in multi-asset portfolios tend to have exposure to traditional inflation hedges, such as gold, energy and property, while equities have -in general- also offered protection since companies can often pass on higher costs to consumers. The fund managers will also be investing in new long-term opportunities that will continue to present themselves, whether in technology, renewables, smaller companies and the emerging markets.
Of the major economies, the U.K appears at most risk of a wages/ prices spiral emerging, on account of the considerable permanent dislocation to the labour market caused by Brexit. This suggests sterling may come under pressure.