As climate joins the global policy mix 

By Peter De Coensel,
CIO Fixed Income at DPAM



    • In this last letter before the summer break, I attempt to construct a framework that invites you to reflect on current valuations across asset classes in financial markets. The long-term axe centers around the impact of climate change on monetary and fiscal policy. The medium-term axe briefly touches on the length of the current business cycle or better expectations that it might be a very short one. The short-term axe is wondering what could trigger a correction in risk assets. Market breadth, be it the participatory intensity along the advance/decline line or the conviction of the global bond counterrally, might be raising a few eyebrows as it wears very thin. In a way, a lot of market participants would welcome a correction in order to provide markets with the required oxygen upon which a next, sound leg can unfold.

    • After a week of cataclysmic floods over large parts of Europe, the climate debate has attracted a great deal of attention. It happens to have been the same week during which the European Commission announced the “Fit for 55” program that aims to cut greenhouse gas (GHG) emissions by 55% by 2030, using 1990 as the base year. By 2019 though, the EU had already cut emissions by 24% from 1990 levels. Thus, the plan would entail a further 31% decrease over the next 9 years. The plan proposes 12 policies, targeting energy, industry, transport (cars, planes and ships making up a quarter of the EU total GHG output) and the heating of buildings. Buildings account for another third of GHG emissions. Industries and households are encouraged to switch towards a greener energy mix. A world-first carbon border tariff system, taxing imports of high-emission goods produced outside of the EU, such as steel and cement, rolled out of the EC idea box. Expect that negotiations will take at least 2 years. The ambition takes a backseat here, notwithstanding inspirational proposals as a sales ban on new combustion engine cars by 2035. Based on nationally-determined contributions (NDCs), by the end of 2020, the UN sounds alarm bells. The promising US, Chinese and EU actions fall far short of achieving the Paris Agreement target of 1.5°C limit. The Intergovernmental Panel on Climate Change (IPCC) calls for a global emissions decline of 45% in 2030 from 2010 levels in order to achieve net-zero by 2050, limiting global warming by around 1.5°C. As you can read, countries and regions are juggling with base years, aspirations differ based on reduction objectives taken from 1990, 2010 or 2016 base years. GHG reduction ambitions should be labelled in absolute numbers as well as in per capita footprint series. At this moment, global GHG emissions are still rising. Everything depends on the strict implementation of NDCs across regions, whilst adopting the UN ‘fair share’ concept, raising the bar for developed market (DM) countries vis-à-vis emerging market (EM) countries. On a per-capita basis, a high responsibility is carried by China and the US, accounting for about 40% of global GHG emissions. We should expect further updates on NDCs ahead of the COP26 summit in Glasgow end of this year. The sobering facts are, however, that currently, anno 2021, NDCs reveal that we are on a path of about 1% of GHG reductions by 2030, in stark contrast to the 45% number above required by the IPCC by 2030. That number goes to 25% if we are to remain below a 2°C rise in global warming. The 55% number is still a compromise, as the EU27 should cut by about 10% more (i.e. 65% versus 1990 levels or about 60% by 2010 levels) to adhere to the Paris Agreement objectives. The main message is the following: climate change control in the hands of the political elite is fragile and prone to slippages. Setting up fiscal policies that support risk mitigation and behavioural change on environmental issues is a necessary condition but is not a sufficient one! Enter monetary policy to increase the probability of success. The ECB, the BoE and, since last week, the BoJ have all co-opted climate risk in the policy mix. Central banks can steer funding channels across governments and corporates on a global scale. The moment cost of funding becomes attractive for enablers and leaders fostering  environmental progress,  lagging businesses and  governments will (and should) start to pay attention. In many cases, the environment might surge to an N°1 strategic objective. Monetary policy could also facilitate funding towards existing or future ventures that propel innovation at large or technological breakthroughs in specific. Fiscal and monetary climate policies should reinforce one another. Again, assessing the gigantic challenge mentioned above, this will require modest levels of funding cost. As the stage is global, I arrive once more in my secular belief that long-term rates are on a convergence path over a 2030 horizon. A convergence path that holds government rates, as well as corporate funding rates, anchored around current levels.

    • The medium-term axe calls for a shorter business cycle as we conquer the COVID-19 pandemic. The global re-opening has caused a lot of friction across demand and supply chains. However, the global economy has shown an amazing resilience and capacity to bounce back. The speed by which output gaps might close also contains the seeds of an early demise of this cycle. Expect overheating conditions to lead to responsible tightening of monetary policy across DM and EM economies. EM is already well underway. Last week, New Zealand called an end to its QE program. More DM countries will follow. The FED will announce a ‘start of taper early 2022’ by the end of summer. Does this rhyme with bullish bond markets over the past month and a half? Yes. Because US-, followed by EU-bond markets have selected the ‘short cycle’ as their base case scenario. Under a short cycle, expect a full interest rate hiking cycle to be modest compared to the past 40 years. The terminal US FED policy rate will not feature 2.25%-2.50%. We might ‘only’ get to 1.25%-1.50%. That is what, partially for sure, explains buoyant US rate markets. It also links up with the longer-term challenges above. Fiscally supportive environmental investments will carry a low return on investment in normal ‘business’ lingo, but a high human and planet ROI. Enforcing negative real rates onto the global investment scene is a by-product of this complex reality.

    • The short-term axe that could trigger a market correction, is the easiest to pin-point. The UK counted 54 thousand positive COVID tests yesterday, Saturday, July 17. July 19 is Freedom Day in the UK. Across US and continental Europe, more countries colour red as new infection waves might hit over September and October. Markets treat such events as tail risk. I hope markets are correct. The moment base and tail risk switch, the correction could be sharp. Vaccination levels are underwhelming across various DM countries, but almost non-existent in EM economies. Mass vaccination is the ticket out of this pandemic. Global mass vaccination will eventually lead to herd immunity and devalue COVID-19 to flu status.


    • A scramble-for-US-Treasuries attitude was omni-present last week. The CPI releases, hitting 5.4% YoY on headline inflation and a near 30-year high of 4.5% on core inflation, were almost treated as a detail notwithstanding marking a second upside surprise in a row. End of the week, Michigan University survey-based short- and long-term inflation expectations also received another small lift. To no avail, as 10-year Treasuries closed at 1.29%, down 7bp, whereas 30-year Treasury rates closed confidently below 2.00% at 1.92%, down 8bp. Inflation expectations (breakeven rates) adjusted higher, +4bp on the 10-year point, closing at 2.33%. The bull episode is gaining traction and given the slower holiday mood ahead, we might have to wait until end of August to get a better clue on future direction.

    • European government bonds (EGB) added another chapter to their recovery stretch, adding 0.56% over the week. Year-to-date, the sector limits the damage to -2.00%. Core German 10-year bunds raced ahead, dropping 6bp to -0.355%. The strength of core EGB markets was too high a hurdle for the EMU periphery, as spreads widened between 3bp to 5bp. The almost joint announcement of the ECB’s and the European Commission’s climate change policies adds proof to our assessment that both institutions are on a highly-collaborative path over the next decade.

    • European investment grade (IG) realized a full recovery since January 1 and investors start hoping for another positive reading over 2021. The IG sector added 25bp over the week. . Few market observers would have predicted such an outcome a couple of months ago. European high yield (HY) posted an 11bp advance over the week, sitting at +3.20% YtD. Both sectors are in fairly good shape, as little fear of negative rating migration is on the horizon. However, short business cycles are less supportive, in hindsight, for credit. So, it will make for a difficult and cumbersome retreat the moment the evidence of tighter policies becomes evident. On the other hand, a less-aggressive hiking cycle might soothe nerves just in time.

    • EM recovered nicely this week and posted a positive return (+0.77% in EUR terms).

    • The Bank of Korea held rates unchanged at 0.50%, with one dissenter in the MPC calling for a rate hike. The tone of the statement and press conference were hawkish, with Governor Lee citing growing demand-side inflation pressure and how prolonged low policy rate would increase side effect. Also, for the MPC, 1 or 2 hikes would not mean tightening of financial conditions and cannot resolve financial imbalance. The governor stated it will be time to discuss policy adjustment from next meeting on. This hawkish tone caused a repricing in local rates. The recent COVID outbreak and the fact that Governor Lee will be replaced in March 2022 (after the Presidential election) leads to think the pace of normalisation will be slower than indicated this week. 

    • Since Jacob Zuma’s arrest last week, and the high court’s denial of his appeal on Friday, protests have spread to major cities and townships in South Africa. Protesters threatened to shut down the KwaZulu-Natal province, unless authorities released former president Jacob Zuma. What started as a protest turned into riots and looting, on the back of strong social inequality and COVID-19 lockdown fatigue. Numerous people have been killed, and some businesses and infrastructure assets have become the target of looters. Since then, the king of the Zulus – who are from the regions where the riots started – called for peace and the government has deployed 25,000 members of the South African National Defence Force to the regions of KwaZulu-Natal and Gauteng. Fitch Ratings estimated that “the unrest is unlikely to affect credit rating… the direct economic impact of riots will be limited to the sovereign’s credit worthiness. The ongoing unrest is affecting critical sectors such as transport, but we assume it will fade soon with only transitory macroeconomic effects. Even if it escalates, the effects on the economy should be temporary and unlikely to affect South Africa’s rating.”

    • The Central Bank of Chile (CBC) is the next central bank that started the tightening cycle with a 25bp monetary police hike to 0.75%. The monetary policy report expects the output gap to narrow quickly, creating the condition for a gradual normalisation, but aiming to keep the policy rate below the neutral level (3.25% – 3.75%) throughout the two-year policy horizon. A lot will depend on the fiscal adjustment that needs to be handled over the next quarters and which will coincide with the election cycle and the new constitution. This weekend, primaries for the Presidential campaign, to be held on November 21, will kick-off. Next to Chile Vamos, the alliance that includes the National Renewal (RN) party of President Sebastian Pinera, two other alliances will contest. Apruebo Dignidad, a new left to far-left front formed by the old Frento Amplio and Chile Digna, and a new centre-left front Unidad Constituyente, formed by the old Progressive Convergence front and Unity for Dignity front, including left Christian Democrats. Polls put Daniel Jadue from the Communist party (and member of the Apruebo Dignidad front) before Joaquin Lavin from the Independent Democratic Union and candidate for the Chile Vamos Front. Equally important is the process of re-writing the Constitution. Elisa Loncon, a representative from the indigenous Mapuche people and politically independent, was elected President of the Constitutional Convention. No political group has secured enough members to obtain a two-third majority in the Convention. Most of the elected are independent, but the overall bias is more tilted to the left. The Convention has 9 months (extendable to 12 months) to draft the constitution. It is expected that the referendum that will approve or reject the new constitution will be held around July/August 2022. Usually, fiscal consolidation and electoral processes do not go hand-in-hand. The ruling coalition will be tempted to focus more on popularity and less on spending, especially with a candidate from the opposition leading the polls.


    • The Glasgow COP 26 will be a moment in history that political leaders should embrace in order to enforce an immediate reversal on GHG emissions. Meeting time is over, time to implement!
    • Fiscal and monetary climate policy actions will mix-up with traditional fiscal and monetary strategies. Current central bank reaction functions will receive climate adaptations. Research is early in the field, but should receive attention.
    • Fiscal policy aspirations on a supra-national level breathe willingness and high ambitions. However, a similar sense of urgency will be required at a national level for a trend change to occur by 2030. We lost precious time since the Paris Climate Accord of 2015 as the US decided to block the global effort between 2016 and 2020.

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