Where curves cross
Inflation and the most recent COVID wave might be near to their peaks. However, both will remain a concern for investors and, particularly, how the virus continues to disrupt supply and distribution and thus prices. If both waves subside, investor confidence should improve, but 2022 looks like being a challenge. Bond returns were negative last year, and this year doesn’t look to be much different even if interest rate expectations are already on the money. Longer term, what happens to inflation is partly going to be determined by the energy transition and, particularly, how we further internalise the cost of carbon emissions.
Prices are the most important market signal. In my first ever economics lesson in high school, the professor made us draw supply and demand curves. I was sixteen and it was a eureka moment with the realisation that if supply and demand shifted, prices would respond. Sounds basic now doesn’t it? Maybe so, but it was that core principle that led to the pursuit of economics at University and as a career in the City of London. The basic principle of supply and demand should not be overlooked in today’s complex world. Inflation is higher because prices have responded to a shift in the global supply of and demand for goods, services and labour. Yes, inflation was beginning to tick a little higher in the US before the COVID-19 pandemic hit (it was 2.3% in December 2019 and had been higher in 2018 before there were signs of a Fed and global trade led slowdown) but it has been the pandemic that has created today’s inflation problem. Demand was able to hold up, supply fell. Just draw the curves.
This is not to downplay inflation. Over the last year the rise in the broad price level has impacted on real incomes and real investment returns. In 2021 the US consumer price index rose by 7% (December to December). The US broad bond market index delivered a nominal total return of -1.58%. So real returns were -8.5% or so. As a bond investor you don’t want too many of those kinds of years. Unfortunately, 2022 might see something of a repeat with inflation set to average 4.5% according to the Bloomberg consensus of economic forecasters. Bond returns are very unlikely to match that. It is not just a US thing either. Real returns for the Euro-zone broad market index were -7.8% last year. The UK market is the same. So, in two out of the last four years, bond returns have been negative in real terms. This again reminds us that most marginal buyers of bonds are not driven by real return expectations but either by policy considerations (central banks) or balance sheet considerations (pension funds, insurance companies and banks). It is supply and demand but what drives supply and demand in the bond market is complex. That is why we put so much emphasis on these “technical” factors when we construct our bond market views.
2022 a challenge for bonds
The outlook for fixed income is not great in this respect. Inflation will remain high, even if we are close to peak year-on-year inflation rates. Total returns from bonds will struggle because interest rates are going up and the perceived supply and demand dynamics are changing as a result of less central bank buying and the upcoming shift towards central banks becoming net sellers. In recent times there has not been two consecutive years of negative broad market bond returns, but it is likely that we will see that this year. The main hope is that yields don’t rise too much and that underlying demand from certain investor groups will remain strong. Certainly, global pension funds are in good shape and have the opportunity to shift out of growth assets into fixed income to secure the current very healthy funding positions (for defined benefit schemes in selected markets).
None of us have lived through such a shock to GDP growth as we saw in the first half of 2020. None of us have lived through the imposition of lockdowns and the implications of that for work, production, supply and social interactivity. It has been an unprecedented period. With hindsight it is no wonder prices have risen because they reflect dramatic shifts in supply in many markets. I read again this week that the number of container ships waiting to unload in Los Angeles ports was back to the highest level. That means delays to deliveries of goods and services and supply not matching demand. Prices will rise if demand is there to justify it. The danger is, of course, that wages rise in response to the higher cost of living and because of labour shortages and this then feeds back into even higher price increases. The jury is still out on how far down this wage-price spiral we have already gone.
Omicron might be a blessing in the end if it becomes the dominant variant of COVID-19. It seems to result in milder illness, especially amongst vaccinated people. There is more and more talk of COVID becoming endemic, meaning it will be easier to live with much like regular flu or the common cold. If that is the case then supply issues should ease and labour markets might see returning workers as COVID related reasons for not participating in the workforce will be reduced. Inflation eventually should respond as demand for goods and services is met by increased supply and reduced impediments to distribution. By 2023, bond returns should be returning to positive in real terms as a result. In the meantime, inflation linked bonds and high yield remain my favoured parts of the fixed income asset class.
Longer term there are some concerns about the impact on the overall rate of inflation from the energy transition. Energy has contributed to the spike in inflation over the last year and, like many sectors, it will have been hit by COVID-19 related disruptions to labour, materials and distribution. There could also be an impact from a higher cost of capital restricting maintenance expenditure as marginal capital allocations are favouring the renewables sector. At the moment, crude oil and natural gas prices remain very elevated and this is causing political problems in many countries. It will also feed into retail energy prices for a good while longer.
There is going to be a cost associated with the transition to net zero. Some of this will come from the difficulties of maintaining overall energy supply during the transition from fossil fuels to renewables and the cost frictions that will be associated with this. Other pressures will come from internalising the cost of carbon emissions to a much greater degree than is the case today. There are compliance markets that charge certain activities for generating carbon and other greenhouse gas emissions. However, a lot of the economy lies outside of these compliance markets. Companies are setting their own carbon reduction targets but there is also going to be a need for carbon offset strategies as well. These are required to move more quickly to net zero than technology and cost curves will allow. Voluntary carbon markets provide the opportunity for companies to offset part of their emissions and this is a growing sector with carbon offset supply coming in the form of renewable energy projects, nature-based solutions like reforestation and emerging technologies for CO2 removal. A recent Mckinsey study suggested that the market for voluntary carbon credits could increase to as much as $50bn in the coming years. Other studies suggest an even bigger market. The problem is, at the moment, the market is fragmented and very heterogenous with differences in the quality of projects (how much carbon do they avoid/sequestrate) and what other benefits they bring. There are efforts underway to standardise the market which ultimately may lead to more transparent pricing for carbon alongside the prices generated in the existing compliance markets like the EU’s Emissions Trading System. The price of carbon at the moment in that system is around €80/tonne of CO2e. In the voluntary markets, prices are much lower and more varied. It will be interesting to see how this market evolves because there are additional benefits that will come from voluntary carbon offset projects (around biodiversity and employment and particularly in terms of North-South economic issues). It is likely that carbon prices do move higher through the increased policy need to encourage the energy transition and through increased demand from corporates for carbon offset measures to enhance their core emissions reduction plans. This could contribute to inflation in the future but the corresponding welfare benefits for the environment and the global economy will be a price worth paying.
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