• As Q3 winds down and Q4 begins we review a few of the contours of the investment climate.
• With Norway’s hike and New Zealand likely to move in early October, the monetary cycle of high-income countries is turning.
• Fiscal policy will also be less stimulative, though Japan and Canada may be exceptions.
• Higher energy prices should be seen as a headwind on growth rather than a boost to the general price level.
• Fears that China’s Evergrande’s demise is going to spark a “Lehman-esque” global financial crisis was overstated.
• The market has barely taken notice of Canada’s election, the LDP leadership contest in Japan, or the German election amid strong signs of continuity. Nor has macabre US fiscal process caused strains (yet).
As Q3 winds down and Q4 begins, the broad investment climate is being shaped by the turning of the monetary cycle. Norway was the first, and New Zealand will be next. It is not so much that these moves will force others to do the same. Instead, the Norges Bank and the RBNZ are simply ahead of the others. Although there is speculation that the Bank of England can move before the end of the year, it seems a stretch. The market feels increasingly confident that the Bank of Canada will raise rates around the middle of 2022. By our calculations, looking at the Fed funds futures, the market has priced in a hike for the September 2022 FOMC meeting and has discounted a little more than a 25% chance of a second hike. The offs may rise toward 50% before finding a new equilibrium.
The European Central Bank, the Bank of Japan, and the Swiss National Bank are notable laggards. However, the ECB’s Pandemic Emergency Purchase Program will wind down and finish at the end of Q1 22. It will, however, continue to buy bonds under the less flexible Asset Purchase Program (~20 bln euros a month). The Bank of Japan has reduced its bond and stock buying with little fanfare and even less impact, which reinforces our argument about the significance of the signaling channel in the efficacy of QE.
The Evergrande problems, which have been evolving for a few months at least, play on anxiety about the debt problem in China, which extends beyond property developers. It may cast a shadow over the investment climate, even though direct foreign exposure appears limited. The Chinese government moved to ensure that funds are used to construct what was promised and paid for rather than servicing creditors. Comparisons with Lehman and the Great Financial Crisis, or even Long-Term Capital, seem misplaced. Maybe a more apt comparison, if one is needed, may be the bankruptcy of GM and Chrysler in 2009, with contained adverse impact.
The jump in energy prices is another dimension to the business and investment climate. Oil, natural gas, and the cost of carbon offsets have appreciated markedly. Brent began the year near $50 and is not traded below $70 this month and set new three-year highs before the week around $78.25. The price of WTI has doubled since the end of last October. That oil prices doubled before the previous three business downturns in the US before the pandemic illustrates its power as a headwind even in a primarily service economy.
Simply put, the oil demand has rebounded quicker than supply. OPEC+ will gradually add 1.2 mln barrels a day in Q4, though US shale is slower to recover, and there was the loss of output and refining capacity due to storms recently.It is slowly returning. Russia has reduced gas supplies to Europe, apparently to pressure the early start to the Nord Stream 2 pipeline while it is also rebuilding its inventories. China reportedly is also revamping its stocks. The weather volatility has seen droughts in some places reduce the supply of hydroelectricity, while dampened winds, for example, in the UK, experience a dramatic decline in this renewable output (though this looks to change soon). Around half of a dozen small retail power providers in the UK have collapsed over the past six weeks or so, impacting an estimated 1.5 million households. The bottom line here is that rising energy prices ought to be considered a knock to growth rather than an inflationary threat, and Europe is particularly vulnerable. Several governments have responded with offsets for the higher household energy bills (~30-40%).
Political developments seemed to have little impact. The process may be unbecoming, but the pending US debt ceiling and spending authorization, which now appear tied to Biden’s infrastructure initiative, have not fazed investors. At the recent auctions, including the 20- and 30-year bonds, indirect bidders, often foreign central banks, have been stronger participants. In addition, Canada’s Liberals lost the popular vote but secured the most parliamentary seats for the second consecutive election. The market looked through it.
In Germany, the SPD is widely expected to lead the next coalition government. Merkel leaves a complex legacy, and Finance Minister Scholz represents much continuity, including the ordo-liberal disdain for the use of fiscal policy to manage aggregate demand in the typical business cycle (of which this isn’t). Instead, the likely center-left government favors measures that curb the most extreme forms of economic inequality. Germany’s foreign policy may be more assertive, as it helps navigate Europe between Russia, China, and America, not putting them on the same level but suggesting a more independent Europe. France seemed to be re-living the Suez Crisis, which reinforces Macron’s Gaullist leanings and gives Le Pen fresh fodder.
Japan’s LDP holds its leadership contest on September 29. The winner will become Japan’s next prime minister and face voters in a Lower House election that has not been scheduled but will occur in the next couple of months. However, the market appears to be looking past it. A large fiscal stimulus package is expected (something of the magnitude of JPY30 trillion or ~$270 bln), which seems to be part of the LDP tradition. The next prime minister may help shape the package and priorities, but there seems to be a consensus favoring it.
In addition to being the Prime Minister during the Olympics, Suga has led the turn in foreign policy. China’s bullying and harassment in the region have provided a new framing for a more muscular military posture that significant parts of the LDP have long advocated. Japan offered unequivocal support for Taiwan if it were attacked by China. This is a step the US has not formally declared. Along with a stimulus package, a more robust defense in the face of an upgraded Chinese threat also appears to enjoy broad backing in the LDP.
The inaugural meeting of the US-EU Trade and Technology Council (TTC) on September 29 looked to be a victim of the French sub snub, but it will be going forward. What appears to be an apology from Biden has begun the rapprochement process. The French ambassador who was recalled will return to the US. On the other hand, UK Prime Minister Johnson may have not gotten the “be contrite” memo and told France in French to “get a grip” and “give him a break.”
Many observers who dismiss Macron’s pique may not appreciate the impact of the numerous slights on the relationship, leaving aside the recognition of the possibility that the US is one election away from another rejection of multilateralism. The list of offenses appears to be growing: The EU travel ban, the ban on exporting vaccines, the withdrawal from Afghanistan, the continuation of the steel and aluminum tariffs imposed by the Trump administration on national security grounds, the treatment of personal data, the unilateral withdrawal from the nuclear agreement with Iran, and threatening sanctions on those that violate the US sanctions on Tehran. The meaning of “America is Back” remains elusive.
Turning to the economic data, one of the reasons high-frequency reports are important for investors is the possible impact on policy. Yet, next week’s data are unlikely to move the major central banks’ needle. This is not to say the information is unimportant. Instead, the recovery from the pandemic is unprecedented, and the trajectory of monetary policy is being shaped by medium-term considerations.
For example, the US reports August durable goods, trade, and inventory data. The Fed has already acknowledged that the economy moderated in July and August, and it still went ahead with its signal that it will begin tapering in Q4. The August personal income and consumption data will help economists forecast Q3 GDP. Retail sales already foretold a strong consumption report, while income growth may have moderated. Savings were likely drawn down to fund consumption.
The headline PCE deflator, which the Fed targets, may have stabilized. The 0.3% rise of the median forecast in the Bloomberg survey would replace a similar increase in August 2020 in the 12-month comparison. That should keep the year-over-year rate steady at around 4.2%. A 0.2% increase in the core rate is expected, which could mean that the year-over-year slips to 3.5% from 3.6%. We continue to see no signs that the Fed prefers the core measure. When it announced the review of its policy and adopted an average rate target, it seemed to underscore the importance that the headline measure is the best, which it could have changed if it wanted.
The eurozone publishes its CPI too, but its estimate is for September. Prices pressures have not peaked, and the ECB seems well aware of it. In September, the euro weakened, and energy prices surged. The base effect also warns upside risks as last September’s 0.1% increase drops out of the year-over-year measure and is bound to be replaced with something higher. The year-over-year rate will move above 3%. The core measure is likely to have accelerated from August’s 1.6% pace. The prices of consumer goods, including apparel and durable household goods, like appliances and furniture, have supply chain issues that drive up prices.
There was a mini-drama recently about comments by a few board members questioning the accuracy of the staff’s recently updated forecasts that saw inflation at 1.5% in 2023. There was also a dispute over what the ECB’s chief economist told or did not tell a private group of German bankers broadly similar a few days earlier. Indeed, given these unprecedented times, we should discount long-term forecasts. Take them with more than a pinch of salt, as it were. The forecast for this year is too low at 2.2%. The cumulative monthly increases are already at 2.4%.
The coming adjustment higher will give the hawks the upper hand at a critical juncture in the evolution of monetary policy. The Pandemic Emergency Purchase Program winds down in the first part of next year before ending as planned in March. The fight is over the size and flexibility of the ongoing Asset Purchase Program. The September 2021 CPI estimate is unlikely to influence that debate. The hawks may insist on ringfencing “temporary” in terms of time and/or level.
Before China goes off to celebrate the Golden Week, the PMI will be reported. Here too, the data will have limited impact on policy. The composite of both the “official” and the “Caixin” iteration fell below the 50 boom/bust level in August. The PMI will not change the perception that the economy has lost much forward momentum, and that seems to be precisely when the over-extended credit system is most vulnerable. That said, some early signs point to a stabilizing situation. Lastly, to prepare for the upcoming holiday, the PBOC will be injecting liquidity into the banking system.
Bannockburn Global Forex