From inflation, inflation, inflation to inflation, growth, credit.

The past couple of weeks have been a very interesting period for global financial markets, with core market central banks and their policy reaction functions to the inflation backdrop (and its expected path) driving wild swings in currency markets and commentator projections alike.

Two weeks ago, in the aftermath of the January Federal Open Markets Committee (FOMC), we wrote about the continued evolution of the Federal Reserve (Fed) hawkish pivot, as the Fed Chairman’s press conference made it clear that the Fed are behind the curve on inflation. He said, in essence, that the Fed are (belatedly it could certainly be argued) addressing the significant inflation overrun and are doing so by accelerating expectations of near-term policy tightening - markets have priced faster US rates and the USD rallied.

Then last week, in the aftermath of the European Central Bank (ECB) meeting, we wrote about the evolution of the ECB, who highlighted a unanimous concern for inflation (potentially dispelling the dovish anchor of a divided Governing Council); and emphasising the potential for accelerating growth, after the Omicron/supply chain restrictions ease in Q2 and beyond. The ECB President refused to repeat the phrase from the December ECB meeting, that rate rises in 2022 were “very unlikely” (potentially opening up the prospect of rate hikes in 2022); and emphasised the need for ‘optionality’ with regard to potential monetary policy paths, in light of inflation uncertainty (although we highlighted that there is a big difference between owning an option and exercising one). The market subsequently disregarded all these ‘potentialities' and swiftly priced 50bps of hikes.

This week, the market continues to focus on the potential capital inflows that could be returned to the eurozone if the ECB are able to get the deposit rate back to zero. Not the likelihood of this happening over the course of the next year, nor the argument that even if eurozone rates got to the heady heights of zero, the US equivalent is likely to be closer to 2% - it is not clear that this widening of rate differentials in favour of the US should drive capital flows out of the USD.

However, from my perspective, the biggest factor in this debate at the moment is one that seems to be curiously lacking from the analyst narrative - growth.

Inflation, inflation, inflation has been the theme of markets for some time now but it is important to note that the inflation in Europe (and the UK), and the inflation in the US are very different phenomenon. If inflation is almost entirely driven by energy / supply chain factors in Europe, then a monetary response that tightens financial conditions will by definition impact demand, or growth. This has been a point that the market has been very comfortable discussing in relation to the UK, but has been lost in the potential capital flow debate in relation to the Eurozone.

In the US, where there is clearly excess demand (the absence of which in the eurozone was noted by the ECB President at her testimony to the European Parliament this week), we see a much more credible argument for Fed normalisation that does not damage growth, and by extension can remain supportive of equities.

Indeed, for equities the market is also, in our view, ignoring the importance of growth. Huge concerted deleveraging in the US tech space in January saw significant price declines, BUT it is not clear that there is a sustainable rationale to shift out of the growth or tech space (outside of the specific stories of work from home/stay at home or, rebalancing of non-profitable tech) at this juncture as a function of rising rates - not even relative to value stocks. Furthermore, it is certainly not clear that there is a case (as has been fervently reinforced by many sell side analysts), that European equities should outperform (driven again by the value > growth sector argument).

With current pricing, the market anticipates the Fed Funds rate getting back close, but not all the way back to pre-Covid levels mid 2023. In the eurozone, we are now pricing a level of deposit rate not seen since the middle of 2014, yet Covid related debt loads, not to mention input cost inflation or continued supply chain frictions, likely continue to damp investment, growth and profitability.

In short, we have discussed a number of times on these blogs , that we see widening growth and yield differentials as a factor driving our preference for USD over EUR (and US growth over value). The recent perceived pivot from the ECB does not change our structural viewpoint, but likely adds widening credit differentials to the medium term debate, again in favour of the US - the current narrative around further, energy related fiscal support for the consumer in Italy and France (and the effective nationalisation of the energy provider in France) show how inflation, growth and credit have become closely linked.

If rates rise with lower growth, then the implications for both sovereign and corporate credit are significant. The ECB may be able to use its newly created policy of transferring the flexibility of the PEPP programme from its purchases to its reinvestment (however dangerously close to monetary financing this may come), and this may well dampen the near term impact on sovereign spreads. However, it is not clear how long this can persist in an environment of rate normalisation (post ‘Emergency’, the E in PEPP), nor that there is a dampening mechanism for slowing consumption of high debt European corporations in the face of rising yields.

The current market dynamic has clearly chosen to prioritise the potential capital flows that might happen if the ECB can get interest rates into non-negative territory (although we concede that there are potentially some flow dynamics related to Environmental Social Governance (ESG) that may come sooner than zero). And not the complications that the direction of travel could have for growth and for credit.

In between writing this piece and it being published, the ECB President commented that the ECB would harm the economy’s rebound if it were to rush to tighten rates, questioning the benefits of rates to offset supply side factors. She went on to state that “if we acted too hastily now, the recovery of our economies could be considerably weaker, and jobs would be jeopardised”. This is much more in line with our thinking, as the title suggests, for now it is all about growth… and credit.