Christmas tidings of comfort, if not joy

17 December 2021

Dear readers, this week’s edition will be the final one for 2021 and we look forward to welcoming you back when we next publish on 7 January 2022. Looking back, the year has exceeded some expectations and underdelivered on others. In terms of our expectations for the economic recovery and capital market performance, 2021 has been better for investors than we dared to hope and forecast at this time last year. On the other hand, I am surely not alone in having hoped the vaccination drives that began one year ago would have ensured further progress in putting the pandemic behind us than where we are now.

The Omicron wave feels like a real setback to the trajectory towards normalisation of our everyday lives. Christmas plans are once again being altered radically, disappointing those expecting a return to their pre-pandemic travel habits. This is not just bad news in respect of our festive activities, but will undoubtedly dent seasonal revenues for retailers and the hospitality sectors.

Yet, over this past week, the Christmas messages we received from central banks was distinctly one of continued normalisation, or rather phasing out of the extraordinary monetary support put in place to see the economy through the worst of the pandemic’s economic shutdowns. This tells us that their economists see the current Omicron episode as short-lived and unlikely to have a material impact on the general upwards direction economies around the world have taken since the beginning of the year.

Benign market moves suggested that central bankers had once again successfully managed market expectation and that most investors similarly see the Omicron episode as likely to be short- lived. However, politicians cannot afford to take a similarly optimistic ‘wait and see’ position, and will have to assume the worst until science informs them of the actual impact on public health of this latest COVID mutation. Until then, prudence and politicians’ natural self-interests dictate making every attempt to reduce transmission, even if it impacts economic activity in the short term.

The hit to consumer and business confidence will be the key follow through for next year. If this strain of the virus is more contagious and less dangerous for most individuals (for whatever reason), it will be important for businesses that they can see the politicians acknowledging the evolution, and adapting accordingly.

The major central banks told us about their expectations for growth in this week’s meetings, and collectively see a reasonably strong growth path being maintained through 2022 and into 2023. This has enabled almost all of them to shift policy away from the current ultra-easiness. Perhaps the most uplifting aspect was that all central bank commentators considered the Omicron outbreak a bump, rather than a barrier. We discuss in more detail the Federal Reserve Open Market Committee’s decisions below (where we also discuss how they may not always be as impressively successful as this week). However, the one central bank that is having a bit of an issue with aspects of its credibility is… the Bank of England (BoE).

The decision by the Monetary policy Committee (MPC) to raise rates on Thursday was a surprise (just as surprising as the decision to not raise rates in November). Yes, the increase was only 15 basis points (bps), taking the base rate from 0.1% to 0.25%, and we should take heart that the MPC too sees the Omicron episode as a temporary influence. One could point out that the BoE’s bond-buying quantitative easing operation ended only very recently and it needed to see if there was any impact before taking any further policy steps. Yet the BoE’s briefing of the underlying situation for December differed very little from that in November and, subsequently, Governor Andrew Bailey seemed to indicate that the path to higher rates was still in the future. In the words of Allan Monks of JP Morgan: “It has been hard to read the BoE’s reaction function of late, and while some members responded to the confusion surrounding the November meeting by saying less rather than more, that only added, in our view, to the difficulty in understanding what they were thinking in the run-up to this meeting… 2021 will not go down as the BoE’s finest for clarity of communications, but at least 2022 brings hope”.

Much of the uncertainty seems to stem from whether inflation has the potential to become a bigger issue that central forecasts have indicated. So, does the UK have a more problematic inflation outlook than others? Are we on a path to much higher rates? Here’s Allan Monks of JPM again: “CPI is on track to climb to a peak of around 5.7% next April and remain close to 3% into 2023 [if there were to be no tightening]. The BoE’s forecasting model imply that 20bps of tightening would be necessary to reduce medium term inflation by 0.1%. This would imply (about) 120bps of tightening would be necessary to return inflation to target. While [JPM’s] forecast does show this level being reached by end-2023, surprises could force the BoE to act faster.”

Right now, however, none of the UK markets are behaving as if there is a big problem brewing. Sterling is stable and the equity market has kept up. If anything, it may have started to outperform.

Another thought we take away from this week’s juxtaposition of central bank direction compared to public health policy is that monetary policymakers have seemingly – and with a certain amount of courage – moved towards a post-pandemic mindset. Meanwhile, politicians have continued to resort to very similar restriction of movement and crowd management policies, just as they have with every previous COVID wave and mutation. Eventually, politicians too will have to decide whether, on balance, it is still constructive to shut down vast parts of societal activities with every new variant. The question will be at what level of public health impact we have reached the point when the virulence of the latest COVID mutation has become comparable to what we have always lived with, and accepted as the natural impact of what we know as seasonal flu.

Since we started the year with Brexit, it may be appropriate to close it also with a thought on Brexit. The outcome of the North Shropshire by-election provided a surprise and unwelcome ‘Christmas gift’ for the Johnson government, but perhaps also marked a shift in priorities that were not mentioned in last night’s victory speeches. The constituents of a previously staunchly Brexit- supporting constituency, perhaps inadvertently, voted for the only party committed to seeking the UK’s eventual return to Europe – an ironic way to give Boris Johnson a bloody nose. Meanwhile, Jersey issued French trawlers with more fishing licenses and the UK’s Northern Ireland Protocol negotiating team conceded that the European Court of Justice may be the arbiter in matters which are considered under European law. Have we moved beyond the dogmatic Brexit and are about to see a more pragmatic way forward? The UK’s economy would certainly be grateful, and provide a good basis for a solid return on such ‘investment’.

The Good Investor

We can all do our bit for a better world. COP26 policymakers have hoped to give it a renewed zeal by clearly extending “all” to a host of private industries that have been historically absent from the environmental debate – including financial services. Former Bank of England Governor Mark Carney and his ‘GFANZ’ (Glasgow Financial Alliance for Net Zero) crew waxed lyrical about how financiers could and should reduce the carbon footprints of their businesses, their assets and their cultures.

They were already pushing at an open door. ‘Green’ and ‘ethical’ investing has been growing reasonably strongly for 20 years. However, for the past five years, ESG investing – where investments are rated not just on their return potential but on their environmental, social and governance credentials – has become increasingly mainstream. ESG ratings are used in analysing individual companies, then aggregated up to whole investment portfolios.

Even funds and portfolios which have no commitment to being particularly ‘ESG’ publish ESG and/or sustainability metrics. However, for those funds that do make a commitment, the prize of investor flow is enormous. Onlookers were sceptical when Mark Carney said GFANZ had committed $130 trillion of capital to net zero targets, but there is undeniably a huge amount of global capital investing in ESG-focused investments. Another trend of recent years for retail investors has been the move towards low-cost ‘passive’ investments. Thus, there has been a particular prize; to create ESG indices.

But the increase in popularity of the ESG label has not been matched by greater clarity or understanding of how the ESG metrics are formed, or what they really mean for the world. We have written before that common standards, definitions, and regulations are essential to getting the financial world behind the green transition. There is still no standard way for assessing a company’s ESG rating.

Different ratings agencies have different methodologies, which can make scores inconsistent. Even for a single agent though, scores may not be directly comparable. Some providers score companies on an industry-specific basis – changing the metric’s weighting towards factors important for that industry. This is good for comparing businesses within a single sector, but tells you very little about cross-sector comparisons. It can throw up some strange results, such as companies with vastly different emissions having the same rating.

Having a single metric for all sectors might help these comparisons, but this inevitably gives lower ratings to companies in ‘bad’ industries. While this might not sound like such a big issue, it increases the likelihood of companies selling off their lower-rated parts (such as those with high emissions) into private hands (also referred to as brown-washing), not solving the problem but simply removing it from the public eye.

Some clever start-ups have sprouted to try and solve these problems and help give better ESG ratings. But their size limits their ability – and there are only a few ratings agencies with the necessary scale. This has led to a situation where ESG investments are still dominated by the same companies who analyse mainstream investments.

Index provider MSCI is one of the biggest providers of ESG ratings, and its scores are used to market ESG funds and portfolios by the world’s largest investment companies. When companies speak of ESG investments, MSCI’s ratings are often what they mean. But the neat presentation of these scores hides a great deal of controversy. For starters, MSCI does not rate the environmental part of ESG as one might hope (Bloomberg recently found that environmental factors were cited in only 26% of the reports they analysed). More importantly, it is not clear that MSCI’s ratings reflect the outcomes important to many ESG investors at all.

Bloomberg’s recent investigation found that many companies were given an upgraded rating for social and governance reasons despite making little change other than codifying existing processes – including bans on bribery or other criminal behaviour. MSCI’s environmental ratings are even more controversial: Bloomberg found that a company’s environmental score has almost nothing to do with its practices, but instead measures how much profit incentive the company has to engage in polluting behaviour.

Blackrock’s iShares is strongly associated with MSCI. Many of Its passive funds are based on MSCI’s indices and the strongest growth segment is in its ESG range. Following the Bloomberg article, Blackrock sent out an explanation of its use of MSCI’s “Implied Temperature Rise” metric this week to allay some of the natural qualms of its investors. However, the document rather underlines the sketchy nature of MSCI’s approach.

The problem here is not whether MSCI’s methodologies are justifiable, but that they give a false sense of security. Even if you think this is a good way to scrutinise a company’s ESG credentials, many others might not, and it cannot be simply taken as a given, especially when transparency is lacking. Investors might benefit from a broader variety of ratings – giving individuals the chance to choose one that aligns with their own values.

There is a deep tension here, though. Investment managers act on their clients’ behalf to maximise value. For the most part, we all agree on what is valuable in an investment – its financial return. When it comes to ethical or environmental considerations, there is no universal agreement. This means that the measures themselves must be evaluated, not just the assets being measured. Active investors might be used to this kind of detective work (indeed, many use a combination of ESG providers and their own work on the underlying data), but passive investors not as much. ESG scores cannot simply be taken as given, and analysis needs to be done at each level of decision making.

These challenges are made more difficult by the lack of available data. There are proposals (such as those floated at COP26) for making ESG reporting mandatory for companies, but there is still some way to go before these analyses can be taken as reliable. Worse still, we know companies are already finding ways of tweaking the data in their favour – the so-called ‘greenwashing’ problem.

These issues can be helped if there is consistent regulation. In the vacuum of ESG rules and definitions, private providers have stepped in to give their own measurements and eye-catching infographics. But these are often opaque and lack the popular backing governments can (sometimes) provide. Things are improving, but policymakers still need to do their bit so that we can do ours.

Fed puts faith in US economy

Kudos to the US Federal Reserve (Fed) for a seamless change of gameplan. Throughout the pandemic, investors (ourselves included) held a lingering fear of ill-timed or ill-sized monetary policy tightening. Historically low interest rates and emergency support measures have helped to keep the economy above water for the last two years, making the onset of their removal a troubling thought. The inevitable finally came true this week: on Wednesday, Fed officials announced a doubling of bond-buying reductions (tapering) starting in January, and the expectation of no less than three interest rate rises to come in 2022. And yet, investors were not alarmed. Far from it, markets had a delightful afternoon – with the S&P 500 rising 1.6% and the tech-heavy Nasdaq jumping 2.2% – even if the rally subsequently fizzled out, as some short-covering price squeezes of those who had bet against the Fed, faded.

Fed chair Jay Powell seems to have a good relationship with capital markets, allowing him to taper asset purchases without the tantrum. And, as with any good relationship, communication is key. Powell and company have spent the whole of 2021 preparing markets for the taper, and when inflation expectations rose, Fed officials gradually but consistently fed in the notion that the pace of tapering could accelerate.

This week’s changes to the ‘dot plot’ (showing how policymakers expect rates to change over the next few years,; see chart below) have brought the Fed’s interest rate outlook more in line with the latest market expectations. Crucially, investors have not interpreted the Fed’s change of pace as a change of destination: indicators of expected longer-term rates were unchanged or down, suggesting markets do not expect rates above 1.5% in the next few years. We have written before that a difficult part of the Fed’s current job is convincing markets that the removal of emergency support should not be a sign of outright hawkishness, and it seems the central bank is doing this well.

That said, officials could have made the case for liquidity management a little clearer. As noted previously, excess liquidity is a big reason for the Fed’s tightening. Moves in money markets have shown that the financial system is close to having more liquidity than it knows what to do with, which could have destabilising consequences. Draining some of this liquidity through tighter policy therefore makes sense, and is a big part of the central bank’s policy. But the Fed chose to focus more on inflation targeting in justifying its faster taper – perhaps because that is far more straightforward to communicate than how and why excess liquidity has manifested itself and become an issue.

However, we can – and should – also consider the effects on other sources of liquidity. Brokerages and market makers provide support for the smooth running of the financial system by keeping money flowing. But since regulation has changed since the global financial crisis, keeping an inventory of US Treasury bonds becomes more expensive – meaning brokers are less likely to step in at times of stress. That risk of stress increases as the Fed withdraws as the major buyer of those bonds, once again leaving the broader liquidity provision in the hand of the private sector. Hence, not only the Fed but also regulators are mulling over reforms as to how smooth liquidity conditions can be maintained. Pressure will likely build even more when the central bank becomes a net seller of bonds (Goldman Sachs analysts expect this will occur in the last quarter of 2022).

All of this restricts trading liquidity. That tends to lead to choppier markets, even if investors are largely optimistic. We should, therefore, expect increased volatility, especially at the short-term maturity end of bond markets. Compounding the issue further is the US government’s upcoming fiscal plans, which will inevitably require lawmakers to raise the federal debt ceiling and issue more bonds. The result is an increase in bond supply at the same time as a drop-off in demand – putting downward pressure on prices (and upward pressure on yields).

These are the usual anxieties that come from stopping emergency treatment. As Powell would point out though, stopping treatment is a necessary part of recovery. We all knew that extraordinary support would have to end sometime – and a normal functioning economy should have the depth and dynamism to survive without it.

In this respect, the Fed’s hawkish turn is a reflection of its positive economic assessment. Tellingly, it removed mention of average inflation targeting – which had previously allowed it to tolerate overshooting the 2% target. Judging by the latest forecasts, officials seem to have decided the pandemic ‘transition phase’ is over. According to Powell: “The economy is so much stronger now, so much closer to full employment, inflation is running well above target and growth is well above potential”.

That is, transition in monetary terms at least. Whether businesses and individuals have enough underlying confidence in the real economy is a different matter, and will be the crucial theme for the next few quarters. Data continues to be positive, but the rapid rise of the Omicron variant poses risks and uncertainties to the global outlook. We have already seen tighter restrictions introduced in Germany, and other countries could follow suit over the winter.

Even without full-scale lockdowns, if COVID concerns worsen people’s behaviour over the Christmas period will inevitably be different from before the pandemic. The travel and leisure industries are once again most at risk – especially if they are unable to tap into emergency support as before. Some have suggested Omicron could be a long-term boon for the global economy if early reports of lower severity prove true. That may be the case, but decreased mobility or confidence over the next few months would still be bad for short-term growth.

Regardless, the Fed clearly sees enough of an upside in growth, employment and inflation to change its tune. The removal of emergency support means it is now up to the real economy to repay the central bank’s fate. Also, a faster pace of tightening means strong and self-sustained growth will have to come faster too. On that front, private sector credit growth will be a key indicator to watch over the coming months. If private lenders can fill the hole left by fiscal and monetary support, the world economy will be in good shape.

Pressure now is on other central banks to communicate their plans. The Bank of England – which has had its own communication problems recently – raised rates already this week. The European Central Bank (ECB), meanwhile, is still pushing the “transitory” rhetoric on inflation. How long that can last remains to be seen. But the market’s response to Fed tightening gives the ECB – and ourselves – confidence for the road ahead.

Please note:

Data used within the Personal Finance Compass is sourced from Bloomberg/FactSet and is only valid for the publication date of this document. The value of your investments can go down as well as up and you may get back less than you originally invested.