Some weeks leave you scratching around for relevant subject matter, other weeks there is almost too much to write about! This occasion is one of the latter.
Inflation & Growth; the markets’ conundrum
This week, a swathe of economic data was apparently pulling in opposite directions. June inflation in the US (headline CPI rather than Core Personal Consumer Expenditure inflation, the Federal Reserve’s preferred measure which removes volatile food and fuel prices) tipped the scales at 5.4%, up from 5% in May. In the UK CPI reached 2.5% against 2.1% in May; for context, it was 0.4% in February.
Inevitably, western policymakers have been forced to react, if not formally then at least by a nodding admission to reality. Former Bank of England chief economist Andy Haldane believes the structural inflation risks are greater than the Bank likes to admit, to which has now been added the voice of Deputy Governor Sir Dave Ramsden: strongly leading the policy witness he projects CPI at 4% by the year-end before possibly subsiding thereafter assuming any overshoot in prices does not itself stoke more enduring inflationary expectations.
In the US, at a House of Representatives Finance Committee hearing, Federal Reserve Chairman Jay Powell, already distinctly vulnerable to the charge of complacency and dithering, was forced to concede that he might have to give way on his ‘lower for longer’ interest rate strategy if corrosive inflation appears to be becoming embedded (note: many ‘might’s, and ‘if’s in his answers as he tries to free himself from the potentially embarrassingly tight corner in to which he has painted himself with his ‘forward guidance’).
If overheating and inflation are preoccupations in the Anglo Saxon economies, the smoke signals from China can produce evidence to suit all agendas: the 7.9% year-on-year GDP growth seen in the April-June quarter narrowly missed consensus estimates of 8.1% and was a country mile away from the 18% recorded in the first quarter (“growth rates have peaked!” shout the pessimists); on the other hand domestic consumption was relatively robust (“a vibrant domestic economy is vital for long-term growth!” declare the optimists). First and second quarter year-on-year comparisons are arguably worthless: Q1 2020 saw peak epidemic rates in Wuhan and China was in full lock-down leading to a 3% economic contraction in the period from which recovery has been sequential every quarter period since. Further confusion lies in apparently contradictory policy responses: on the one hand the central authorities have actively been constraining access to credit ostensibly to try and prevent the economy from overheating, yet last week they cut the minimum capital reserves which banks must maintain for fiscal probity reasons, in order to free up lending capacity. Read into that what you will! Meanwhile in an interview this week in Europe, ECB President Christine Lagarde revealed her increasing anxiety about the fragility of eurozone recovery as the Delta variant of Covid becomes widespread.
Against this seemingly contradictory backdrop, bond market opinion currently remains unconvinced of the medium-long-term inflation threat. Amid all the talk of tapering central bank asset purchases, bond investors are now largely assuming it will in fact happen so have already factored it in to prices. The preoccupation is whether economic recovery will meet expectations and beyond the recovery phase, whether longer-term growth rates will be above/at/below long-term historic trends. Which neatly leads to the next twist in the great decarbonisation revolution.
Brussels’ pre-emptive climate change strike: protectionist or pragmatic?
Regular readers of these columns will be quite familiar with the increasing velocity of environmental diktats with shorter and shorter ambition dates in the competitive race to achieve carbon net-zero by 2050. This week has seen a major development in governments getting to grips with the reality of dreaming up hard policies and their implementation to get us there. In the UK, joining the government consultation paper already in circulation about decarbonising the UK domestic housing stock (see Merlin Macro Update 23rd April), Boris is now confronting the realities of what a ban on new combustion-engine vehicles from 2030 actually means, given D-Day (or is it EV-Day, or H-Day?) is only eight-and-a-half years away: what will be the preferred or dominant technology, EV or hydrogen? Do we have the supporting infrastructure to keep us moving (clearly not, and difficult to address without the previous answer being settled)? Who will pay for it? How do we replace the £34bn in lost government revenues (today, the size of the combined budgets of the Department for Transport and the Ministry of Justice) currently raised by fuel duties?
But away from these domestic issues, more significantly and jumping the gun on the COP26 climate conference, Brussels has announced a far-reaching statement of policy intent, potentially some elements of which have major geopolitical consequences. Among a raft of policies, two at least are contentious: first, on the polluter-pays principle, the carbon credit trading system will be reformed, phasing out the issuance of free credits currently available, a system which has so far made it easier for polluters to buy credits in the market from those with surpluses to sell, rather than fundamentally tackling their own emissions. Excess demand has already forced credit prices to rocket, adding significantly to business costs especially in energy-intensive industries. The latest initiative simply adds to the burden (the political psychology, a typically blunt behavioural instrument, being that it incentivises companies to address their own carbon emissions when the cost of physical remedial action is lower than that of simply paying somebody else to abrogate their responsibilities). However, to create a level playing field, the EU insists that countries which do not operate such a system (e.g. the US) need to fall in line. Carbon nihilists (those seeking a zero-carbon economy as distinct from net-zero) will still be unimpressed with this latest Brussels’ development, perceiving all forms of carbon offset mechanisms as ‘greenwashing’.
Second is the intention to throw a carbon border around the EU. Many countries, including the UK, have ‘off-shored’ significant percentages of their emissions liabilities by replacing domestically produced energy-intensive goods with imports (e.g. steel, cement etc) from cheaper sources abroad. Brussels plans to address what it sees as a competitive anomaly by taxing the imported goods’ total carbon footprint including the original source of manufacture and the shipping content. Predictably, importers complain of the unfairness and the exporters at the other end of the chain claim this is merely another tariff, an unfair additional burden placed on them. China is alleging such a policy subverts WTO rules and is threatening retaliation against what it perceives to be a deliberately protectionist ploy.
With by far the majority of countries fully signed-up members of the Paris Climate Accord (only Turkey, Iran and Iraq are the countries of any economic significance which are not signatories), it is easy to be seduced into thinking that environmental unanimity equals universal peace, love and harmony. However, as the programme moves into its next phase, governments are now confronting the detail of translating fine words and aspirations into hard policy and even harder economic and political reality. Every policy requires significant changes in personal, corporate and national behaviours all with major costs attached. It is inevitable that international carbon competition will accelerate, tensions will rise and national interests will potentially collide. Will the race to decarbonise radically change the nature of global trade? Will countries need to become more self-reliant? Can countries afford to do it? Can they afford not to? What happens to personal freedoms, notably the freedom to travel? Can politicians pull their electorates along with them? All of these, and more, are open-ended questions the answers to which will become apparent over time.
From an investment standpoint some of the consequences are immediately obvious, notably how ESG is palpably changing investor and investee company behaviours. In time, although the bar is certain to be pushed higher, it is not unreasonable to suppose that as all companies tend towards conformity, it will no longer be a case of a premium rating being attached to the standard-bearers so much as a discount being accorded to the under-achievers, if they remain in business at all! But the geopolitical jockeying for position and competitive advantage will also be reflected in term and risk premia as well as exchange rates. This revolution by coercion has only just begun. Like it or not, it is going to be a fascinating ride!
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