Alpha, beta, gamma, delta,… these Greek letters play an important role in the world of your favorite asset manager in the financial analysis of shares. In the meantime, they also refer to the various mutations of the coronavirus. The delta variant is currently dominant and is more contagious than previous mutations, but in the Western world, the high vaccination rate is limiting the societal impact.
After an initial sharp contraction of the economy, the economic recovery followed swiftly, which now goes hand in hand with the speed of the vaccination campaigns. Although regional differences are still large, many countries will leave the economic corona valley behind in the coming months. Christine Lagarde, president of the European Central Bank, put it this way: "We're back from the brink, but not out of the woods". A positive, albeit vigilant vision. For example, the low vaccination rate in developing countries and the emergence of new, vaccine-resistant mutations pose a risk to the current growth trend of the global economy. In addition, the exceptionally fast recovery itself also has adverse side effects. Disruptions of the production chains lead to skyrocketing inflation, favorable financing conditions encourage excessive debt increases and (geo-)political decisions expose new problems.
Economic growth is slowing down a bit
The industrial sector proved to be the engine of the recovery in the global economy after the initial dip in the first half of last year. With the reopening of the economy, the consumer's focus is shifting from purchasing goods to using services. As the service sector is the most important component of Western economies, economic growth expectations for 2021 have been significantly boosted. The ECB revised growth expectations for the EU even higher for this year from 4.6% in June to 5.0% in September. Nevertheless, the peak of economic growth seems to have been reached. The spread of the delta variant is forcing various governments to maintain or even tighten up the restrictive measures, which again slow down the recovery of the service sector. In addition, the growth impulse in the industrial sector also appears to be diminishing. Shortages in factors of production, including suitable labor and raw materials, are forcing the hot-running sectors to cool down. The recent purchasing managers' index of the Chinese industrial sector even shows a small contraction compared to a month earlier. The problems can be found on the supply side of the economy, as business and consumer confidence stays relatively high and demand remains strong for now. The prices will go up as a result, and someone will have to foot the bill.
Price rises not so temporary after all?
Central banks often defined higher inflation in recent months as a temporary effect, pointing to the lower year-on-year comparison base when the global economy's pause button was pressed. But now inflation seems to be more persistent than previously thought. Core inflation does not include volatile components such as energy and food prices in the calculation. While core inflation in the United States stood at 4.0% in August, it soared to 1.9% in the eurozone. The targets of the central banks in the eurozone and the United States are an average inflation rate of 2.0%. Core inflation in the eurozone is still below this target for the time being, but prices are still on the rise. European companies saw producer prices explode (+12%) due to interruptions in the logistics and production chains and soaring energy prices. If they want to maintain their profit margins, they will steadily try to pass the cost increase on to their customers and ultimately to the consumer. Consumers and unions will then include these price increases in wage negotiations. In addition, many sectors are experiencing an uncomfortably tight labor market, resulting in more wage pressures. All these factors are important drivers for higher inflation in the longer term. The case for temporary inflation is thus weakening. And because the problems are on the supply side of the economy, the term stagflation is increasingly being coined: the situation where the economy slows down, while inflation and unemployment are high. This scenario would pose a major dilemma for central banks’ monetary policies.
Tipping point in monetary policy is in sight
Central banks are very wary of a stagflation scenario. After all, they have to combat low economic growth and high unemployment with an expansionary monetary policy, while countering high inflation requires a restrictive monetary policy. It is no surprise that the economic shock from the corona pandemic led to an expansionary monetary policy. In the past year and a half, the G4 central banks (Eurozone, United States, United Kingdom and Japan) have already put 23% of their total GDP on their balance sheets, mainly through bond purchases. After the 2008 financial crisis, it took them eight years to buy the same amount, even though GDP was even smaller then. Meanwhile, the balance sheet total of these central banks continued to grow, to just under 60% of their GDP. The US, UK and European central banks will discuss the phased reduction of monthly interventions in the coming months. But this does not imply a reduction in the balance sheet totals of the central banks, because with the cash released from maturing bonds, the banks will still buy new bonds. Only after the gradual moderation of interventions will central banks also consider increases in policy rates. We are therefore moving towards a pivotal point in monetary policy, which will change very gradually and which will support the economy for some time to come. However, corporate and government bond yields with longer maturities will already experience upward pressures as stimulus is phased out, while short-term yields will remain low.
Credit risk fees are extremely low
Central bank monetary stimulus lowered government bond yields and pushed down corporate bond yields. The difference between the most creditworthy bonds (government bonds) and the corporate bonds with the lowest Investment Grade rating (BBB rating) quickly declined to a particularly low level in the second half of 2020. Before the financial crisis, these spreads were even lower than today, but then 5-year US government bond yields fluctuated between 3% and 5%. This interest rate stands now at 1%. The compensation for credit risk therefore fell sharply, while government bonds often priced in negative interest rates. This very low compensation for credit risk in an environment of negative government bond yields means that you no longer get compensated for the higher inflation, and therefore lose purchasing power, even if you invest in corporate bonds. In addition, a possible rise in interest rates due to the easing of monetary stimuli will weigh on bond prices. As a rule, bonds, with their fixed interest rate or coupon, serve to bring stability to an investment portfolio. However, in the current circumstances, interest rate risk (the chance that interest rates will rise) is gaining in importance, and alertness is advised.
Xi Jinping advocates shared prosperity
The Chinese Communist Party (CCP) led by President Xi Jinping has made regular headlines over the past quarter, introducing a new set of regulations and restrictions. Education companies are no longer allowed to make a profit and Chinese children are only allowed to play video games for three hours a week. Supervision of data security of the Chinese tech giants is being tightened. Why is Beijing intervening now? The pandemic has increased inequality in China and strengthened the power of certain tech companies. This led to suspicions among the CCP. The pursuit of shared prosperity for all Chinese will therefore form an important guideline in the Chinese governing policy in the coming years. So there are still some additional regulations to come. But in line with the Made in China 2025 strategy, which envisions a strengthening of domestic consumption and technological dominance in the global economy, the CCP is more likely to watch closely than to steal growth. The strong economic growth means that Chinese GDP will catch up with American GDP in the coming years, while they already left the European Union’s GDP behind for a while. Yet the Chinese economy per capita still is much lower than the Western levels. The fact is that the focus on strengthening the domestic market and one's own prosperity can once again give rise to geopolitical tensions.
Featured quotes • “The peak of economic growth has about been reached.” • “Central banks are very wary of a stagflation scenario.” • “Low credit risk fees make it difficult for bond investors to maintain purchasing power.” • “The CCP will watch closely rather than steal growth.”
Macro Economist and Wealth Manager at Econopolis.