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Will 2022 go down in financial history as the year the music stopped? After the extraordinary buoyancy in markets in 2021 the risk of a painful downturn is certainly escalating.
In weighing that risk, investors face one overwhelmingly uncomfortable fact — central banks continue to rig the markets through their asset purchasing programmes, with important consequences for private portfolios.
The expansion of central bank balance sheets started as a response to the great financial crisis of 2007-09 and accelerated when the pandemic struck in March 2020.
This monetary activism perpetuates a looking-glass world where supposedly safe assets such as index-linked government bonds yield a negative income.
While they may remain safe in the sense that they offer liquidity, they are nonetheless toxic because they ensure a guaranteed loss if the investment is held to maturity. At the same time, most nominal government bonds currently show a negative real yield after adjusting for inflation.
One implication is that a traditional well-structured, diversified portfolio — split 60/40 between equities and bonds — has long been unhelpful for retail investors because bonds have lost their traditional insurance quality.
Another is that investors have been forced to take on more risk, notably in equities, while risk across many markets is underpriced.
In effect, the central banks have subverted the markets’ capacity to establish realistic prices. And as I pointed out in FT Money a year ago, bond investors face reinvestment risk whereby investments providing a good income today cannot be replaced by equally attractive investments when they reach maturity.
The flood of central bank liquidity has caused valuations to become stretched, most notably in the US where the cyclically-adjusted price/earnings ratio invented by Nobel laureate Robert Shiller reached 38.3 in autumn last year, fast approaching the multiple of 44.2 notched up at the peak of the dotcom boom.
This is the second-highest peak in 150 years, says Chris Watling of Longview Economics, a consultancy. US stock market capitalisation as a multiple of gross national product — a measure favoured by billionaire investor Warren Buffett — hit an all time record of 2.8 in the second quarter of 2021, compared with a dotcom peak of 1.9.
The symptoms of an equity bubble are rife in the US: witness the Spac phenomenon where blank cheque companies bring private companies to market while circumventing the protections afforded by conventional initial public offerings. Share prices of money-losing businesses are being ramped up, notably in the tech sector. Boston-based fund manager GMO points out that 60 per cent of the growth stocks in the Russell 3000 index make no money. And this was true even before the Covid-induced recession. Meanwhile, small retail purchases of US equity options have grown explosively in volume and speculation in crypto assets is increasingly frenetic.
While some of these bubble characteristics such as Spacs and crypto speculation are now affecting Europe, equity valuations in the eurozone, the UK and Japan are not so conspicuously stretched.
The UK, in particular, is shunned by many international investors because of a perceived paucity of growth companies, worries about Brexit-induced lower economic growth and a disproportionate number of fossil-fuel-intensive companies in the indices. Yet the bond markets in Europe and Japan are subject to the same underpricing of risk as in the US. And the rest of the world’s markets will surely feel the backwash when the US equity bubble bursts.
Economists and actuaries tend to equate risk with volatility. But for mere mortals the most damaging risk is loss of capital. It is worth noting that the 2021 Credit Suisse Global Investment Returns Year Book records that from the peak of the dotcom boom in 2000 to March 2003 US stocks fell 45 per cent, UK equity prices halved and German stocks fell by two-thirds.
What might cause the bond market bubble and the US equity market bubble to burst? A new and devastating variant of the coronavirus is an obvious possibility. But in a market overwhelmingly driven by policy the more predictable catalyst is policy reversal.
Having initially argued that the surge in inflation since the pandemic struck in March last year was transitory, central bankers are now edging towards a less sanguine view. The fiscal policy boost in the US since the Covid shock has been huge in relation to plausible guesses about the size of the output gap, which records the amount of slack in the economy.
This contributes to demand pull inflation. Meanwhile, companies have found that they can pass on cost inflation arising from supply shortages relatively easily to customers. They are also conceding higher wages in a tight labour market. The same factors are at work in the UK and continental Europe, though the fiscal numbers are on a lesser scale than in the US.
There is a strong likelihood, then, that the big increase in money supply arising from ultra-loose monetary policy will be reflected in higher prices of goods and services in contrast to the period after the 2007-09 financial crisis where monetary expansion simply boosted asset prices.
In today’s more inflationary environment, the US Federal Reserve and other central banks are reining back, or “tapering”, their asset purchases, which have been an important prop to bond and equity markets. For its part, the Bank of England’s monetary policy committee raised its policy rate by 0.15 percentage points to 0.25 per cent in December. Central bankers have long been anxious to return to a level of interest rates closer to historical norms, which would give them greater ammunition to restimulate the economy in the event of a new financial crisis or recession.
Markets appear to be anticipating that normalisation will not cause much pain. While the debate over inflation and policy tightening has raged there has been no “taper tantrum” of the kind that caused markets to fall out of bed in 2013. One explanation could be that investors think the economic recovery since Covid will remain sufficiently robust to absorb any tightening.
Another offered by Jeremy Grantham, co-founder of GMO and noted for his prescience in spotting bubbles, is that more than in any other previous bubble investors are relying on accommodative monetary conditions and zero real rates going on indefinitely. This has a similar effect to assuming peak economic performance for ever; it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices.
The problem for those who detect a bubble is that predicting the timing of the burst is notoriously difficult. In addition, moving into cash carries a heavy penalty at today’s rates of inflation. The difficulty for central bankers is that tightening policy may prove more financially destabilising than markets now expect because of an extraordinary accumulation of debt since the financial crisis. This is a direct consequence of the low interest rates which create a huge incentive to borrow.
The Institute of International Finance, a trade body, estimates that global debt at the end of 2021 amounted to $295tn, $36tn above pre-pandemic levels. This amounts to just under 350 per cent of global gross domestic product, compared with 282 per cent at the start of the financial crisis.
That tells us the extent to which global growth has been debt dependent while also pointing to a vulnerability. Rising interest rates will raise government borrowing costs and hit the large number of so-called zombie companies that are unable to cover debt-servicing costs from long-run profits but have been kept afloat by ultra-loose monetary policy. And if rate rises cause markets to plunge they could expose vulnerabilities in the banking system and among lightly-regulated shadow banks.
The problem is compounded because monetary tightening will coincide with a reduction in fiscal support. John Llewellyn and Saul Eslake of Llewellyn Consulting, a UK economic advisory company, point out that whereas in 2020 the general government fiscal balance of the G20 economies supported aggregate demand to the tune of 8.8 per cent of gross domestic product (GDP), the IMF estimates that support in 2021is likely to have fallen back to 7.9 per cent and on present budgetary plans to fall further in 2022 to 5.9 per cent. They worry that with the economic recovery not yet fully assured, this joint fiscal and monetary tightening looks premature and risky.
One all too plausible outcome is that financial instability arising from a sudden repricing of risk across the markets will cause central bankers to reverse course for fear of precipitating a harsh recession. That would entrench investors’ belief in a perpetual safety net under the markets and set off a further round of debt accumulation, implying a lesser check on inflation and a bigger crisis down the road.
Equally plausible is a prolonged bout of stagflation, which is bad for investors. Looking at bond and equity returns in 17 OECD countries back to the late 19th century TS Lombard’s Dario Perkins has identified episodes of stagflation, defined as years in which per capita GDP grew by less than 1 per cent and the headline CPI inflation rate was above 4 per cent. These episodes threw up significant real losses for investors. On average across the sample stagflation was associated with a 3 per cent real loss for equity holders and a 7.5 per cent real loss for bondholders.
Note, too, that in the last serious period of stagflation in the 1970s bonds and equities became positively correlated, so that bonds lost their insurance quality and became an additional source of risk.
Of the other risks faced by investors China demands attention. An overheated housing market and overborrowed property sector highlight the unstable nature of the credit fuelled growth model of the world’s second-largest economy. The People’s Bank of China, the central bank, moved before Christmas to ease financial conditions and the authorities still have enough fiscal capacity to stabilise a financial crisis. But flagging economic growth in the lower single figures seems likely in the light of these upsets, which will amount to a headwind for the world economy. That said, a slowdown would lead to lower commodity prices and a weaker currency, which would help the developed world cope with inflation.
For foreign investors in China the picture is complicated by Beijing’s punitive recent assault on big tech and private education companies, its arbitrary interventions in markets and its clamp down on offshore financial vehicles through which companies such as Didi Chuxing, Alibaba and Pinduodo listed in the US.
As for direct investment in Chinese equities and bonds, they are at a potentially-attractive discount to developed world counterparts. The question for investors is whether the discount is sufficient relative to the risks, which include growing political pressure in the US to decouple from the Chinese economy. Another issue concerns how they feel about human rights abuses in China.
Climate risk is rising up the agenda. It poses a threat both through physical disasters such as extreme weather and potential corporate losses from decarbonisation as fossil-fuel-intensive assets have to be scrapped.
Companies’ disclosure around plans for the transition to low carbon is exceptionally patchy and there is a widespread perception that climate transition risks are not efficiently priced in the markets.
This means that there are opportunities as well as risks for investors. But beware regulatory risk. There could be big losses for companies and investors if governments adopt more widespread carbon pricing.
Finally there is geopolitical risk, notably in the renewed assertiveness of Russia and China. History suggests that markets are not good at anticipating adverse geopolitical outcomes — witness the buoyancy of the London stock market before the assassination of Austrian Archduke Franz Ferdinand in June 1914.
How should investors cope with a more inflationary environment where monetary policy is clearly changing gear and so many assets look overvalued? After years of dreadful underperformance, value stocks should do much better relative to growth stocks in the coming decade.
The big US tech stocks now confront rising regulatory risk from competition authorities around the world. It is worth recalling how in the 1960s so-called nifty fifty growth stocks eventually came unstuck. Among the supposedly nifty were the likes of Kodak, Xerox and Polaroid — tech leaders of the day that were brutally disrupted by innovative newcomers.
Emerging market equity valuations look very low by historic standards against the US and could offer interesting opportunities. The very depressed ratings of UK equities also look like a potential value opportunity.
With bonds losing their insurance quality, finding assets that offer diversification for equities is important. That points to commodities, gold and for some, crypto assets. These offer no income. That said, the first two have defensive qualities against inflation. Whether that is true of crypto is historically untested. It seems questionable whether these super-intangible, ultra-volatile assets should be regarded as diversifiers as opposed to an outright punt.
Finally, real assets such as property and infrastructure make sense in an unstable inflationary environment. Since the start of the Covid pandemic, alternative property like warehouses, care homes and student accommodation looks less risky than offices and retail. For retail investors the problem is to find the right fund through which to gain exposure to these asset classes.
The biggest challenge for investors is the one identified by GMO’s Grantham, who remarked last year: “The one reality you can never change is that a higher-priced asset will produce a lower return than a lower priced asset.
“You can’t have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both — and the price we pay for having this market go higher and higher is a lower 10-year return from the peak.”
Prepare for the proverbial bumpy ride.
Sometime in the spring of 2020, Sam O’Leary’s phone began ringing off the hook.
The callers were managers from the auto and aerospace industries. They were all seeking help from his industrial 3D printing business in Germany, SLM, in producing vital parts that were suddenly becoming scarce as the Covid-19 pandemic disrupted international shipping.
“I didn’t do a single day away from the office,” says O’Leary, who took to showing off the company’s specialised machines to clients over video calls. His customers’ worries were always the same, he says: “I’ve got a massive problem, I need to de-risk, I need to reshore.”
SLM’s customers had hitherto used its technology for niche applications, such as producing gooseneck brackets for planes and brake callipers for performance vehicles.
But, despite the increased cost and complexity of 3D printing metal components, they turned to the technology for more commonplace parts — such as hinges that keep regular car seats in place.
So, while many other industrial businesses saw their order intake slow to a standstill, revenues at the Lübeck-based company — whose shares had fallen to record lows before the pandemic hit — grew by more than a quarter in 2020.
Sales were on track to have increased by a similar amount in 2021. For 2022, O’Leary expects SLM’s sales to grow by 40 per cent.
High-profile disruptions to global supply chains in the past couple of years — including the temporary blockage of the Suez Canal, floods and fires in Texas and Japan, as well as ongoing semiconductor production bottlenecks — have led to similarly rosy forecasts for the rest of the so-called “additive manufacturing” sector.
Last year, a study by Lux Research estimated that the market for 3D printed parts, which was worth $12bn in 2020, would grow to well over $50bn by the end of the decade.
Governments across the world have sought to address how, and where, components are made. In Germany, the recent chronic shortage of semiconductors led to millions fewer cars being produced than customers wanted to order. As a result, it is one of many countries to have pledged to support the “reshoring” of crucial component manufacturing to protect their economies.
But, despite such enthusiasm, evidence increasingly points to the fact that businesses like SLM are serving a small market.
A survey of European companies conducted by EY in the early spring lockdowns of 2020 found that more than four-fifths were considering bringing their supply chains closer to home. When the same survey was conducted in April last year, however, that view was shared by just 20 per cent of respondents.
Similarly, only 15 per cent of the multinational companies surveyed by the Association of German Chambers of Industry and Commerce (DIHK) said they would relocate production.
Their stance was echoed by sports goods group Adidas. Just five years ago, the company launched a scheme to build factories in Germany and the US that would use local materials and advanced manufacturing techniques, such as 3D printing, to produce bespoke trainers for nearby customers.
It had to all but abandon this plan as the Covid-19 pandemic began. But, after supply chain disruptions cut Adidas’ revenue growth by around €600 million in the three months to the end of September 2021, boss Kasper Rorsted was adamant that he had not changed his view on reshoring manufacturing.
“We have approximately 800,000 people deployed in our [suppliers’] factories,” he said in November. “It is an illusion to believe that you can move an industry that has grown over 30 years in Asia, to a very sophisticated industry, to some regions.”
Even if that was theoretically possible, Rorsted added, raw materials would still need to be sourced from around the world to produce the parts, making the prospect of reshoring a “total illusion”.
“You wouldn’t even be able to find the people [that would need to do the work currently being done in Asia],” he said.
Economists in Germany are also unconvinced.
“If the EU were to decouple even partially from international supply networks, this would considerably worsen the standard of living for people inside the EU as well as for its trading partners, and should thus be avoided by all means,” warns Alexander Sandkamp. He is one of the authors of a study by the Kiel Institute for the World Economy that suggested that regionalising production would cost Europe hundreds of billions of euros.
The recent flood disasters in Germany, which cost the country €40bn, according to insurance group Munich Re, was further proof that “shocks can also occur on our doorstep,” Sandkamp adds.
Even SLM’s O’Leary is quick to add a caveat to his company’s bullish forecast.
“We work primarily with regulated industries,” he says. “So, if you’re in an aerospace supply chain . . . you don’t just buy a 3D printer and say: ‘OK, well, I’ve decided to move away from my supplier wherever [they are] in the world and I’m going to do this in-house’.”
A recent development programme with a major UK aero-engine manufacturer, he adds, took two years to get up and running, due to the time needed to install the necessary machines on-site and get the necessary approvals from Britain’s Civil Aviation Authority.
“The demand is definitely increasing,” says O’Leary. “But there’s also a reality in that this is a technology and a change that is regulated and takes time.”
Additional reporting by Olaf Storbeck
In October last year, Volvo Group unveiled the world’s first vehicle made using “green” steel. The autonomous electric truck weighed eight tonnes and was designed for use in quarries and mines.
It was the result of an industrial partnership between Swedish steelmaker SSAB, the state-owned electricity generator Vattenfall, and iron-ore miner LKAB. Their aim was to make the first steel free of fossil fuel by replacing the coking coal traditionally used in its manufacture with green hydrogen.
The partnership, dubbed “Hybrit”, is at the cutting-edge of European industry efforts to develop more energy-efficient, low-carbon manufacturing techniques.
Many initiatives were already under way before the coronavirus hit, but the pandemic has focused industrial leaders’ minds on the importance of reshaping and strengthening supply chains, and coping with longer-term challenges — in particular, climate change.
“It is no longer about the lowest cost producer, it is about resilience in your supply chain,” says Stephen Phipson, chief executive of British trade body, Make UK.
Manufacturing executives in the UK, he points out, are re-evaluating ‘just-in-time’ manufacturing processes and how much inventory to hold in future to ensure greater resilience. The importance of skills has also moved up the agenda, especially as companies battle to attract and maintain workers after the pandemic, which has left many short of staff.
But business leaders caution that wholesale transformation will not happen overnight.
A survey by McKinsey last November underlined the challenges. In a previous survey, in May 2020, most companies stated that they planned to pursue several paths to improve supply-chain resilience, including diversifying supply bases. But, in practice, by the end of 2021, most had mainly increased their inventories.
The more recent survey found that 61 per cent of companies had increased inventory of critical products and 55 per cent had taken action to ensure they had at least two sources of raw materials. Only 11 per cent had “nearshored” production, to avoid the risks of disruption from geographically remote suppliers.
Duncan Johnston, UK manufacturing leader at Deloitte, says: “Changing things in manufacturing takes time. You can’t change what was a global supply chain into something that is more near-shored or UK-centric very quickly”.
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The same, he says, is true of sustainability ambitions. While companies have done some thinking about it, they have not yet “really embarked on the substantial journey that is needed to reduce carbon emissions in the UK economy”.
Manufacturers face several challenges along the way. Apart from reducing the emissions in their own processes, they need to consider those in their supply chain. They need to find new ways to power their activities and, in some cases, such as the automotive sector, completely re-engineer their products.
Heavy manufacturing industries, such as steel and cement, are among those at the forefront of efforts to decarbonise countries’ economies. Outside of power generation, the iron and steel sector is the largest industrial producer of carbon dioxide. It accounts for 7 per cent-9 per cent of all direct fossil fuel emissions, according to the World Steel Association.
To meet global climate and energy goals, the steel industry’s emissions must fall by at least half by the middle of the century, according to the International Energy Agency. Achieving such a reduction will require more than incremental improvements in the efficiency of traditional blast furnaces.
“We have come to a point where, in terms of efficiency improvement efforts, there is not much more room left,” says Martin Pei, chief technical officer at SSAB. “It is really breakthrough technology that we are looking at now.”
In the blast furnace process, companies use carbon to take oxygen from iron ore to get iron. SSAB will instead use clean hydrogen gas, produced in a facility called an electrolyser powered by Sweden’s abundant renewable electricity. The output will be a solid intermediate, called sponge iron, which goes into an electric arc furnace, where it is mixed with scrap and refined into steel.
The successful production of Volvo’s first heavy-duty truck shows that the “whole value chain works,” says Pei.
SSAB has estimated that metal from its hydrogen-based process will, at least initially, be 20-30 per cent more expensive than conventional production. Pei, however, says that customers are keen and that demand for greener steel is growing as more and more companies commit to decarbonising their supply chains.
Policymakers will need to play their part, too, in helping manufacturers transition to a low-carbon economy. For Europe’s steel industry to switch en masse to hydrogen, for example, would require a massive expansion of renewable power. State support would be needed to fund the necessary investment in expanding power grids and other infrastructure to accommodate the transformation to low-carbon economies.
Hydrogen is a prime example. The EU and the UK have both published ambitious plans to develop a hydrogen economy but obstacles remain to making this a commercial reality.
For example, says Phipson, the UK has a “very small innovative sector on hydrogen . . . the challenge is to scale that up”. Britain, he adds, is very good on innovation and research funding but what is needed is “scale-up capital”.
As for funding sources, he says: “There is a big commitment from companies to use private capital but the government also needs to play its part.”
Transforming the workforce to deal with this transition is another concern. Even before the pandemic, manufacturers were worried about the effects of an ageing workforce and how to attract younger talent with more digital skills.
“We don’t know any manufacturing business that has as much in the way of digital skills as they would like,” says Johnston.
Those worries have grown, with many employers emerging from the pandemic with even more unfilled jobs. Phipson wants to see more action from the government on this front, as well.
“[It] needs to get more ambitious about its skills,” he believes. At the moment, the skills shortage is a “drag on growth”.
Ayatollah Ruhollah Khomeini once said the purpose of the 1979 revolution in Iran was to promote Islam, not the economy. Focusing on the latter would reduce human beings to animals, according to the founder of the Islamic republic.
More than four decades later, the regime’s ideology and hostility to the US remain intact but the economy is very much at the forefront of leaders’ minds. New president Ebrahim Raisi has sought to assure Iranians that his priorities were tackling economic woes and boosting their welfare.
The solution has been adopting a “resistance economy” against sanctions imposed by Washington, which accuses Tehran of developing the atomic bomb and fomenting terror operations in the Middle East. Iran can foil hundreds of US punitive measures by focusing on its domestic market; curbing its reliance on imports; increasing exports of non-oil goods to neighbours; and selling more oil to China.
Iran’s leaders say the economy has started growing again as a result. Indeed, the Islamic republic has weathered some of the biggest economic and military threats in recent years, a resilience partly reflected in the World Bank’s latest report.
In its economic forecasts published last week, the international lender said Iran’s economy was “gradually recovering following a lost decade (2011-2020) of negligible economic growth”.
After a two-year contraction, Iran’s gross domestic product grew by 6.2 per cent year on year in the period from March to May, the first quarter of the country’s 2021-22 fiscal year. This was thanks to expansion in oil and services sectors and less stringent Covid-19 restrictions.
Meanwhile, oil production — Iran’s lifeline — is rising: it reached 2.4 mbpd in January-November 2021, although it is still behind the pre-sanction level of 3.8 mbpd in 2017, the bank said.
The positive developments have emboldened Tehran at a time when its diplomats are negotiating with world powers in Vienna to resurrect the 2015 nuclear deal, from which the US under Donald Trump withdrew in 2018. Iran promises it will roll back its huge nuclear advances only if the US lifts all sanctions first and guarantees no other US leader would abandon the deal. Economic resistance would continue if not.
Hardliners in Tehran, who control the Islamic republic’s most powerful bodies, shrug off warnings at home that such a stance could dearly cost the country as well as the regime in the long run.
The World Bank report noted that GDP growth was “from a low base”. It said real GDP in the previous financial year ended in March 2021 stood at the same level as a decade ago “while the country forewent the demographic window of opportunity (a highly educated young population)”. The latest economic rebound “only marginally reduced” the income gap with economies in the Gulf, the report noted.
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In Iran, patience is running thin. Iranians say numbers are meaningless when their purchasing power is being eaten away with 43.4 per cent inflation (even though it has started going down). Inflation coupled with high unemployment and fluctuations in the currency and capital markets is fuelling pessimism.
The government’s plans to further cut subsidies on basic commodities and medicine have heightened inflationary fears. Masoud Mir-Kazemi, Iran’s vice-president for budget affairs, said Iran could at most earn a net income of $16bn in petrodollars next financial year, just enough to import basic commodities and pay civil servants. “We are under sanctions and it’s impossible” not to slash subsidies, he said last week.
But for a regime that came to power through street protests, fears of history repeating itself, this time against the Islamic republic, are never far. Demonstrations are no longer sparked by the educated middle class to demand more social and political freedoms. Recent protests have been mostly over economic woes, whether caused by the government or by a severe drought.
Mehdi Asgari, a member of parliament opposing a cut in subsidies, said last week that more than 10m families struggled with poverty “and millions more [were] heading” in that direction. “They no longer can afford meat and rice and now you want to take away their bread and cheese, too?”
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