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Monetary authorities of developed countries face a gordian knot problem. Will, or even better, can they take bold policy action in the face of faltering real growth, ill-functioning labour markets and persistent, uncomfortably-high inflation readings? Global bond markets are losing patience and have aggressively pulled forward policy rate lift-off into 2022. Premature or not?
First, taking the latest data points across China and US as our guide, global real growth over Q3 has dropped towards an annualised 3.2% pace. A far cry from the close to 6% estimates for 2021 that were in vogue end of Q2 or just a couple of weeks ago during the IMF gatherings in Washington DC. Expectations crystallise around 4.5% annualised global real growth over Q4. Supply chain constraints are stickier than expected. The main indicators to track are manufacturing delivery times and producer pricing indices. The Business Outlook Survey Diffusion Index on Delivery Times issued by the Philadelphia Federal Reserve Bank sits at 32.2, representing an all-time high for a series that started in May 1968. Producer pricing indices across the US, China and the EU post a 11.8%, 10.7% and 13.4% YoY increase respectively. Companies will have no other option than to confront customers with extended delivery times, partial pass-through of higher input costs or a mix of both. In a society that has gotten used to next-day delivery across e-commerce platforms, it begs the question whether we have already witnessed the highs on inflation prints? Nevertheless, it seems that a recovery towards pre-COVID levels on a global output will require more time, taking us well into 2023. From a narrative of pent-up demand problems, we might have hit the fast-forward button to demand destruction. The acute tightening of energy markets is affecting terms of trade, demand-supply conditions and global output potential. As energy cost takes a bigger slice out of world GDP, the rest of the economy in the shape of savings, investments or other consumption categories will face decline. Whereas I put a 20% probability on a stagflation scenario a couple of weeks ago, conviction has dropped. Markets might increasingly prepare for a 2022 stagflation episode. An element of concern becomes the outlook for emerging market (EM) growth over 2022. EM central banks are ramping up policy rate tightening. Russia, Brazil, Eastern European countries, Chili and others are aggressively adjusting policy rates in order to quell inflation and re-anchor inflation expectations. Brazil stands out, as the central bank prepares to hike by 125bp or more this week as inflation is rising above 10% alongside the Bolsonaro government relaxing fiscal caps. Re-election odds must improve for Bolsonaro. Consensus figures for Brazilian real GDP growth over 2022 have dropped towards a poor 1.00%… Local currency yield curve inversion is a distinct possibility. The IMF predicts global real GDP growth at 4.9% over 2022. Both developed market (DM) and EM economies will require better standings than exhibited today in order to fulfil that tally over 2022.
Secondly, labour markets face a multitude of challenges. Labour force participation rates face concerning recovery difficulties. The labour demand-supply mismatch exhibit fault lines as a result of pandemic-related government policy. The ‘Quits’ cohort, as tracked by the Bureau of Labour Statistics (BLS), is rising across many industries. Governments-issued pandemic-relief checks, rent freezes or student-loan forgiveness are resulting in a Big Resignation wave. The bottlenecks in Leisure and Hospitality (i.e. lack of restaurant waiters) spring to mind but broaden to trucker or health care worker shortages. As a result, lower-income wages are rising at the fastest pace since decades. The pandemic has changed the way people perceive work. The flexible work schemes are an answer to the call for a healthier work-life balance. As such, the current drop in participation rates might be transitory. Maybe the transitory word has been mistakenly linked to inflation and should rather have been attached to the labour frictions that percolate today.
That brings us to the third unknown faced by DM central banks that is embodied by the future inflation path. US market-based inflation expectations give a clear answer. However, the answer has two parts: US inflation might be higher-for-longer and US real rates will be deeply negative-for-longer. US 10-year inflation expectations closed at 2.64% last Friday. The highest reading in 10-year breakevens occurred over March 2005 at 2.71%. The US TIPS market started back in 1997. US 2-year inflation expectations closed at 3.07% representing a 2-year real yield at -2.51% versus a nominal comparator at +0.56% (January 2024). 10-year real yields closed at -1.00%, representing a drop by 11bp since the September 22 FED meeting. 10-year nominal yields rose by 34bp since then (i.e. from 1.30% to 1.64%). 30-year inflation expectations clocked at 2.41%. The comparison to 2004-2005 reveals an interesting difference, as, back then, the high was 3.00%! This should provide some comfort to the Federal Open Market Committee (FOMC) as they assemble on November 3. Expect a contingent-based tapering announcement. Over the past week, Powell pushed back on rising expectations of interest rate adjustments as early as the summer of 2022. The balancing act for DM central banks is humongous. Energy inflation tightens economic conditions. Smart observers put this reality as an equivalent of about 100bp of rate hikes. In the eurozone, the ECB will avoid and manage cliff risk over March 2022 by announcing a gradual reduction in PEPP monthly purchases towards the APP 20 billion per month pre-pandemic condition. An earlier return to 0.00% deposit rates over 2023 is in the cards, as that would limit costs for the banking sector and defuse potential misfortune in real estate and equity markets down the road.
One can conclude that nominal DM yield curves flatten as a result of the conflicting messages across real growth, labour markets and producer-consumer inflation. We enter an episode that is sensitive to policy errors. An attentive participant acknowledges that market implied volatility across rates is rising. The Merrill Lynch Option Volatility Estimate (MOVE index), based on implied volatility on 1 -month Treasury options across the US yield curve, rose towards 72. The long-term average sits at 92. The fear of rising rates is climbing but, as this index encompasses calls and puts, the direction can be both ways. Fact is that nervousness in bond markets is on the rise.
At the same time, the VIX index, as the main equity ‘fear gauge’, closed at 15.43, well below its longer-term 19.6 average reading. Equity markets enjoy another season of earning beats. Companies have locked in long-term financing at historically low levels. As is the case for governments, the impact of rising rates on the company’s cost of debt profile will only be felt over a complete rate and credit cycle. We still need to make a start on both.
The preference by DM central banks goes to a well- guided and protracted policy rate normalisation. Sudden and frantic policy behaviour that has grown within the Monetary Policy Committee of the Bank of England is to be avoided. Cutting the Gordian knot aggressively might tilt economic recovery towards recessionary-like challenges too early.