Panorama - March 2022 -
Central banks facing several dilemmas
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
In reaction to the Covid-19 crisis, central banks have ventured into “civilian” life. What they have done has been both helpful and popular.
But now that global economic activity has surpassed its 2019 level and inflation is at a 40-year high, monetary policies must move back to normal. But what about this war in Europe?
The post-Covid world is more heavily indebted, more dangerous, more socially fragmented and confronted more urgently with climate change. Can the world do without this “societal role” being played by the central banks?
Context and analysis
Just as the world was gradually emerging from the pandemic, it faces a huge new problem, one that is noneconomic and non-financial in nature – the war in Ukraine, with repercussions that are impossible to predict in the short term.
While the crisis appears to have engendered a new wave of solidarity in the Western world and particularly in Europe (as occurred during the Covid-19 crisis, with the stimulus plan and its funding through debt in the European Commission’s name), the outcome of the conflict is potentially highly dangerous and could produce severe economic repercussions.
This is the first short-term dilemma for the central banks. Up till now, global growth looked solid, as it was expected at between 4.0% and 4.5%, including 3.9% in the United States and 4.4% in Europe. China’s economy is being slowed by its real-estate crisis and regulation measures, but it has embarked on a new cycle of monetary and fiscal stimulus to meet its growth target of 5.0% to 5.5% “at any cost”.
This target may now be in jeopardy. For one thing, the acceleration that the conflict is causing in prices of energy and some farm commodities, and the psychological impact of a war in Europe could undermine consumer and business confidence. How will central banks react to this risk at a time when inflation is showing no signs of weakening?
The trajectory towards the exit from highly accommodative monetary policies has already been laid down, and normalisation is set to begin in 2022. The main central banks have served notice of their plans to shrink their balance sheets by slowing the pace of asset purchases until they halt them completely within a few months. The US Federal Reserve has already begun to taper off its purchases; the Bank of England is on the verge of doing so; and ECB will halt its purchases completely in March.
The widest divergences are on the issue of key rate levels. The Bank of England has already begun to take action, in December raising its rate from 0.10% to 0.25%, and then to 0.50%. As for the US Fed Funds rate, the consensus had thus far priced in six to seven hikes, with the first one amounting to 0.50% and coming as early as in March and the others taking it to 1.50%/1.75% by this December. In the euro zone, the ECB has shifted gears on inflation and no longer thinks that it will be so transitory. But no change in its main key rate is yet on its agenda, although some differences of opinion are beginning to show up publicly among ECB monetary policy committee members. The next big event will be the Fed’s 16-17 March meeting. Barring an improvement in the situation in Ukraine, the Fed may hike by just 25 basis points.
In the longer term, central banks have no choice but to support governments in meeting the huge challenges that they will be facing, including the following:
- Current geopolitical news serves as a reminder that global governance is not up to the task, and tensions are ratcheting up. The “cold war” between China and the United States has provided ample evidence of this in recent years. Russia’s attack on Ukraine is another illustration. The consequences are clear: in this unstable world, military spending will increase. Germany has just announced that it will now spend the equivalent of 2% of its GDP on defence, and we expect others to follow suit. After several decades of stability and peace, many countries are becoming aware of the materiality of dangers after having fallen behind in military investments.
- Similarly, current geopolitical tensions, along with the Covid-19 crisis have provided food for thought on how production chains should be organised. Making things where it is least expensive and most efficient to do so, in a world with integrated trade routes and low tariff barriers, now looks obsolete, for reasons of both supply security and carbon footprints. Altering these logistics paths will require heavy investment, both private and public.
- There has also been greater awareness of climate change challenges in the past two years among both consumers and companies. This is very good news and shows that the road to a 1.5°C or 2.0°C trajectory will not be linear but, more likely, exponential. This leaves us with lots of hope but also entails considerable investment. For one thing, CO2-intensive production capacity will have to be dismantled and replaced by the same capacity of decarbonated energy.
- And, lastly, societal challenges are among the most important challenges. As we exit the pandemic, ordinary people are taking a very dim view of the runup in prices of financial assets and, even more so, real estate. True, unemployment has declined, but access to a “comfortable” lifestyle looks to be out of reach for too many households, and this is causing discontent in many countries. This is one factor behind the Chinese authorities’ decision to launch its “common prosperity” plan. In short, governments will not be imposing austerity policies any time soon.
Central banks will therefore be key players in meeting these challenges. In light of current events, we have the feeling they will be more accommodative over the long term than what is expected in terms of monetary normalisation. As a result, government bond yields in the safest countries – the United States and Germany – could remain rather low and level off, respectively, at 2.0% and around 0.25% in the coming months. Beyond that, they could remain low for a long time to come, even if that entails real rates’ remaining negative and a rise in inflation.
As for equities, levels reached by the main indices now look attractive once again. Valuations have fallen considerably, and earnings forecasts have been upgraded in recent weeks. But we are not in a “normal” situation. Geopolitics is likely to keep risk premiums high on short-term markets, as developments in the war in Ukraine are unpredictable and could change quickly with no fathomable justification.
Unfortunately, in cases like this, analysis of economic fundamentals takes a back seat to political developments, on which there is little visibility. With that in mind, we are sticking to our neutral stance on equities.
Central banks: Between Scylla and Charybdis
The conflict in Ukraine has brought normalisation of interest rates to a halt just as the pandemic was ending.
Amidst a risk-averse context on the equity markets, yields have fallen by about 20 basis points in the United States and by 30 basis points in Europe. On top of the traditional flight to quality during periods of uncertainty, several other factors are causing yields to fall. Central banks will have to be more cautious in their monetary tightening than what the market had expected, as the economic impact of the war and its related sanctions are hard to grasp just yet, particularly in Europe. These factors have caused a steep drop in 10-year real rates by about 50 basis points. Meanwhile, 10-year inflation expectations are up sharply, by about 20 basis points, driven by two factors: less rapid tightening by central banks in their attempt to bring inflation under control, and expectations of a more sustained bout of inflation, particularly in energy prices, owing to the conflict. The risks of stagflation in the event of a drawn-out, or escalated war have clearly risen.
Beyond the very short term, in which visibility is very low, the potential impacts on growth and inflation are likely to lead bond yields ultimately lower than previously expected, to 2.00% on 10-year US paper and 0.25% on the Bund.
In light of this, breakevens* are likely to continue holding up and offering real protection in the event of a worsening in the conflict, particularly with new energy sanctions that would trigger a spike in oil & gas prices.
In investment grade credit, the widening in spreads that we expected to occur later this year came to pass, in fact, after Russia’s invasion of Ukraine. Against this backdrop and with a yield (1.26%) up sharply since August (0.13%), the asset class is attractive once again.
In high yield, Yield, we reiterate our positive view. Volatility will remain high, and repositioning will probably have to unfold in several stages, but spreads had already been hit by the earlier-than-expected monetary tightening. Central banks are now on a more wait-and-see posture and will therefore have to counterbalance some risk-aversion. Yields are already attractive in this category, at 4.50% in Europe.
Valuations are attractive, but…
Momentum in good surprises is continuing in equities. Fourth-quarter results have beaten forecasts on both the top and bottom lines. Most companies are able to pass on their much higher input costs amidst ongoing tightness in supply chains. The economic outlook remains solid, with order books often exceeding expectations. At the sector level, those companies that are closest to the endconsumer, such as in consumer staples, are nonetheless likely to suffer an erosion in their margins in percentage terms, but most will try to preserve them in total amounts. Pricing power – i.e., companies’ ability to pass on higher costs into end-prices – will be one of the key criteria in stock-picking this year.
After their recent declines, equity markets are once again back to valuations that are attractive on fundamentals. This is especially the case for Europe, with a 2022 P/E (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of close to 13x. However, Europe is also the region most at risk from the war in Ukraine. On top of the danger to people in Ukraine, a prolongation of the conflict and toughening of sanctions against Russia would have negative impacts on prices and/or access to commodities, as well as on companies’ pace of growth and profitability. Conversely, a resolution of the crisis would be a buying signal. We are therefore sticking to our neutral stance for the moment, pending greater visibility on the conflict.
Our central scenario
The unpredictability of the outcome and repercussions from the conflict in Ukraine makes it hard to express any short-term view, given how impenetrable Putin’s reactions and goals are.
Against this backdrop, central banks will have to be more cautious and accommodative, particularly in Europe, in dealing with the risks to growth. Meanwhile, inflation is now less under control, as it could be driven up sharply if energy sanctions are ratcheted up. This, in turn, would engender new risks of economic slowdown.
While equity market valuations – in the macroeconomic and microeconomic environment that prevailed prior to the invasion of Ukraine – look attractive, a cautious approach is best before taking back on any exposure. It is hard to see a way out of this conflict any time soon in which all sides save face. Involvement by China, which has been conspicuous by its absence so far, could tip the balance and redraw the lines. However, China is in the midst of an economic slowdown that it has just barely begun to control.
Conversely, an entrenched, higher-intensity conflict could trigger a phase of economic slowdown, paired with high inflation, thus raising fears of a phase of stagflation. In short, the markets will continue to focus on the central banks.
Document completed on 02/03/2022
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com