In the beginning was the American Rescue Plan Act of 2021
Macro Point
Inflation has been a major economic concern in recent years. Initially seen as transitory, it has continued to rise, exceeding the expectations of most economists. The economic recovery, the appearance of variants, the war in Ukraine and the shutdown of the Chinese economy all contributed.
Inflation was initially seen as transitory, due to temporary factors such as global supply chain disruptions and economic recovery from the Covid-19 pandemic. However, it continued to rise, exceeding the expectations of the Fed, which was forced to raise interest rates by an historic amount.
We’re all facing the same inflationary push, but the situation is different in Europe and the United States. This difference is due to a supply shock linked to the war in Ukraine. Europe is more dependent on energy and food imports than the United States, making it more vulnerable to rising prices for these goods.
Of course, there is demand-driven inflation in Europe, but it is less significant than in the United States. Monetary policy, by its very nature, acts primarily on demand by influencing the cost of money and the quantity of money in circulation. US monetary policy is therefore more likely to have an impact on inflation than the monetary policy of the European Central Bank, which also faces supply shocks.
Graph: Inflation worldwide
Sources: Bloomberg, Richelieu Gestion
Inflation is a major issue around the world, but as far as the financial markets are concerned, we believe that US inflation and the resulting monetary policy are at the heart of allocation decisions.
In retrospect, most experts were surprised by the strength of inflation, but when we go back to 2021, long before inflation took off, Keynesian economists like Larry Summers and Olivier Blanchard were pitted against Keynesian economists like Janet Yellen and Paul Krugman.
As we pointed out in our February 2021 monthly review, the debate was a tough one. History has proved the former right.
In the beginning was the American Rescue Plan Act of 2021.
Joe Biden’s stimulus plan has sparked controversy among leading Democratic economists. Some, like Larry Summers, former Treasury Secretary and economic advisor to Barack Obama, have warned of the risk of inflation.
In February 2021, Summers and Paul Krugman, winner of the Nobel Prize in Economics, debated this topic at the Princeton School. The title of the debate was eloquent: “ Will Biden’s stimulus plan lead to inflation? “
Larry Summers made four points:
The $1.9 trillion stimulus package is “extremely large“, and the amount of spending is well in excess of the estimated production shortfall.
It goes“far beyond what is necessary” to help the victims of the Covid-19 crisis.
“We risk a kind of inflationary collision” if the package pushes up inflation, the Fed could inadvertently provoke a recession by trying to stifle inflation with higher interest rates.
This money would be better spent on long-term public investment.
Olivier Blanchard, former IMF chief economist, has also sounded the alarm. Alternatively, he proposes to finance part of it through a capital gains tax. Faced with these concerns, some economists believe that the risk of not doing enough to help reduce unemployment is greater than the risk of inflation.
Here are a few more details on Summers’ arguments:
He compared Biden’s stimulus package to that of 2009, which was about half the size of the production deficit at the time.
He also pointed out that Biden’s plan is six times larger than the deficit to be closed.
He concluded that Biden’s plan was“a very risky gamble” that could“lead to negative economic consequences“.
His analysis was an important reminder that economic policies can have long-term effects.
He wasn’t the only one to think so. Olivier Blanchard, former chief economist at the International Monetary Fund (IMF), also sounded the alarm. If the amount of the new stimulus package was adopted by Congress, Olivier Blanchard alternatively proposed to finance part of it through a capital gains tax. He felt this would be“fair, offer protection and limit overheating“. Faced with these concerns, some economists felt that the risk of not doing enough to help reduce unemployment was greater than the risk of inflation. He proposed to finance part of it through a capital gains tax, which is a tax on profits made on the sale of an asset, such as a share or real estate. He also felt that the taxwould “offer protection” against inflation by reducing the amount of money in circulation.
Tweet from Olivier Blanchard
Source : X (ex Twitter)
In 2021, Paul Krugman, Janet Yellen and Jerome Powell were among the many economists who argued that inflation was transitory.
Paul Krugman, Nobel laureate in economics, wrote in the New York Times in July 2021 that inflation was high, but due to temporary factors. He said supply chain disruptions should ease as the global economy recovers from the pandemic. And consumer spending should normalize as households take on more and more debt.
Treasury Secretary Janet Yellen repeatedly stated in 2021 that she was convinced inflation was transitory and that the biggest risk was that the US would not do enough to cope with the pandemic and public health problems.
Federal Reserve Chairman Jerome Powell also said in 2021 that future inflation spikes would be temporary, that the central bank would not be forced to raise interest rates faster than expected. He maintained that a rapid return to high inflationary trends was unlikely after 25 years of steady disinflation, and insisted that the Fed had the tools to fight inflation should it occur.
The debate raged, and there was a plethora of exchanges in articles and on social networks. Larry Summers defended his opinion piece in the Washington Post by saying that, as the headline stated, ” Biden’s plan is remarkably ambitious “. But it also carries big risks, and“it’s probably a mistake” for young economists to assume that inflation will never be a problem again.
Source : The Washington Post
Paul Krugman responded by echoing the line of his own New York Times column, entitled “ Bidenis the big spender America wants “. Biden’s plan was to be seen as a bailout, not a stimulus. ” Think of it as disaster relief or war. When Pearl Harbor is attacked, we don’t say: How big is the production gap? ”
Paul Krugman’s article is an argument in favor of Joe Biden’s spending plan. Krugman argues that Americans want a big spender and that Biden’s plan is a good investment for the future. Krugman cites polls showing that Americans are willing to pay for investment in infrastructure, education and healthcare. He maintains that these investments will create jobs, stimulate economic growth and improve the quality of life for Americans. Krugman acknowledges that there are risks associated with Biden’s plan, such as inflation and an increase in the budget deficit. However, he maintained that these risks were manageable.
Source : The Washington Post
Joe Biden’s stimulus package, adopted in March 2021, was a massive fiscal shock for the US economy. The plan injected $1,900 billion into the economy, equivalent to around 9% of GDP. This fiscal shock had a positive impact on the US economy. It has helped boost economic growth, create jobs and reduce unemployment. However, this stimulus package also raised concerns about the possibility of the economy overheating.
Unfortunately, some of them played the Cassandra.
Source : X
In December 2021,” Fed Chairman Jerome Powell half-heartedly told Congress. We tend to use the term “transitory” to mean that it will not leave a permanent mark in the form of higher inflation. I think it’s probably time to withdraw that word and try to explain more clearly what we mean.“.
In June 2022, almost a year and a half later, it was mea-culpa time….
Janet Yellen : “I think I was wrong at the time about the trajectory inflation would take.“, she said on CNN. “There were major unforeseen shocks that drove up energy and food prices, and supply bottlenecks that severely affected our economy and that I didn’t fully understand at the time.. “1
In an article published in the New York Times in June 2022, Krugman writes:”I was one of the many economists who argued that inflation was transitory. I made a mistake.” 2
As for the Fed, it wasn’t until its January 2023 FOMC meeting when it stopped using the word “transitory” to describe inflation. In its press release, it stated that “.the forces driving inflation are stronger than expected and inflation is likely to remain high for some time“.
Fed Chairman Jerome Powell said the Fed was“determined to bring inflation back to its 2% target“.
A sequence not without effect on the current situation. But beyond the errors of assessment, there will also be consequences in the months to come.
Bringing inflation back in line with the central bank’s 2% target is undoubtedly the priority.
But doubts persist, as Atlanta Fed President Raphael Bostic reminded us
Source : X
A more constructive attitude would be to reach a level of rates that allows us to act on demand without having to lower rates (and putting a new piece in the inflationary machine).
Graph : Inflation worldwide
Sources: Richelieu Group, Bloomberg
At the risk of repeating ourselves, we are convinced that the Fed will continue, whatever happens, to keep up the pressure to avoid a resurgence in inflation for two fundamental reasons :
– One historical reason : the fear of another wave of inflation, as in the 70s, by boosting the economy too vigorously.
– A psychological reason : given the misinterpretations of inflation in 2021 and 2022, we fail to see how the US central bank can claim victory and loosen the stranglehold of its monetary policy.
The risk would be to overdo it until ” cracks… “.
The monetary authorities are no longer willing to comment on their forecasts and remain, for the time being, ” data dependant “, which shows that econometric models are obsolete in this historic situation.
Global allocation: the US sets the pace
In the short term, we believe that markets could rebound on the back of rather positive news from the United States. We are convinced that, in the short term, the FED will set the pace. The structural challenges in Europe and the cyclical challenges in the United States remain, but the exaggerated optimism of recent months is now confronted by a similar pessimism. The US economy has proved surprisingly resilient to Fed tightening. Business was surprisingly brisk, and rates exceeded our forecasts. At the same time, a gradual disinflation is taking hold, with good visibility for the end of the year. We are keeping a close eye on the catalysts of another inflationary wave, but it seems to be somewhat postponed in our current scenario.
The good news is that central banks are taking into account the end of monetary tightening. To determine the extent of additional policy tightening that might be appropriate to bring inflation back to 2%, we need to take into account ” the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial factors “(Jerome Powell).
The challenges are not the same in the three main geographic zones. Europe is at risk of stagflation, China at risk of deflation (a classic phenomenon after a real estate crisis of this magnitude).). Possible good news from Asia could benefit Europe.
China inflation indicator
Sources : Bloomberg, Groupe Richelieu
Against this backdrop, we recommend that those with liquidity use it flexibly. More volatility and perhaps further declines are likely, but the valuation and prevailing pessimism allow us to act contrarian in the face of a Fed that has made its intentions clear. The Bull-and-bear indicator falls to an all-time low in a context of bearish positioning.
Market sentiment indicator
Sources: Bloomberg, Richelieu Group
We continue to believe that scissors effects will materialize in the coming months (see our monthly update on September), but our negative stance on equities since the summer has proved wise. Our baseline scenario calls for continued disinflation in the US and below-trend economic expansion, with stable corporate margins. We have been overweight Cash since March 2023. We are lowering our recommendation in favor of equities Against this backdrop, we are raising our view on equities from underweight to neutral, without becoming overly optimistic.
US EQUITIES : STEADY GROWTH AND A CALMER FED
Artificial intelligence and budget spending support US equities. Signs of concern about growth are postponed until the second half of the year. The US market should hold up unless the ISM manufacturing index rises above 55 or the yield on 10-year US Treasuries exceeds 5%. Technology stocks are still worth holding on to, but we believe that given the sector’s strong outperformance, we should no longer be overweight, preferring companies in more cyclical and profitable sectors that have already corrected significantly. Dividend appeal is a key criterion in a high interest rate environment. The positive aspect for equity markets definitely remains the potential change in Fed expectations in the future. The S&P 500 index has fallen by 10% in recent months, and many stocks have fallen much more sharply. The cyclical sectors of the market have weakened in relative terms. However, the pullback also seems exaggerated, with many indicators flashing oversold levels. Our 12-month targets remain modest, as for all equity markets. While the market is clearly reacting to geopolitical events, we are reaching the heart of the earnings season, with investors having to reconcile legitimate fears of an economic slowdown (higher interest rates, student loan payments, geopolitical fears, global weakening) with the reality of significant GDP acceleration in Q3 2023 and somewhat improving consensus EPS forecasts. In the short term, the challenge is to assess the extent of the expected slowdown in growth after a very good third quarter. The depletion of savings and the forthcoming slowdown in job creation and wages will be two major catalysts for an imminent halt to growth. According to Bloomberg, “Despite booming growth and a resilient job market, more middle-class Americans are worried about the state of the economy than a year ago “, according to a Harris poll. One of the main reasons: the rapid rise in interest rates deployed by the Federal Reserve to curb inflation, which is now expected to remain high for longer.
This expected slowdown should fuel the disinflationary trend that continues to materialize, with the underlying PCE index for September coming in at +3.7%. The direction of US financial assets and the dollar will continue to be closely linked to the first statistics of the fourth quarter. Disappointing ISM employment or activity data would be a key first step in ensuring the sustainability of the decline in sovereign yields and the dollar.
Leading economic indicators
Sources : Bloomberg, Groupe Richelieu
EUROPEAN EQUITIES : AND BE CONTRARIAN IN THE SHORT TERM
The earnings season has intensified, with almost half of European companies publishing their results. At this stage, investors were faced with a series of profit warnings, which were aggressively punished. These warnings were concentrated in the consumer discretionary and industrial sectors, with many companies forecasting a sharp deceleration in demand in 2024. As for specific stocks, there were many significant movements, including Worldline (-53%), Siemens Energy (-20%), Sanofi (-15%), Standard Chartered (-15%), Rémy Cointreau (-13%), Natwest (-12%) and Moncler (-8%). The market movements following these profit warnings are the biggest in history. Discrimination is increasingly strong at sector level, where consumer and industrial sectors continue to suffer from Asia’s economic weakness and financing conditions, but also at intra-sector level. This shows that, over and above Europe’s structural problems, value selection makes perfect sense under current conditions. When you have higher rates, there is much greater discrimination between companies.
The rapid and vigorous deterioration in economic indicators is forcing the ECB to remain on hold, contrary to our expectations. The ECB will have to strike a balance between two contradictory objectives: fighting inflation while avoiding a recession. In the short term, investors may view these measures as good news on the inflation front. The ECB took these measures to combat inflation, which peaked at 8.6% in June 2023. It said it was ready to take additional measures if necessary to keep inflation close to its 2% target. The ECB’s decision to end its net asset purchases is a clear signal that it is determined to fight inflation. The second more encouraging short-term development is the stabilization (for the moment fragile) of Chinese growth. Outflows from European equities were very strong. We are now adopting a neutral position in the short term, taking into account these two factors (ECB and China), and of course the Fed’s more dovish tones, even if longer-term strategic challenges remain.
CHINA: CLEAN-UP OPERATION
A sluggish economic recovery, combined with debt servicing problems, justifies even lower interest rates in China. With only a few weeks left for Evergrande to avoid liquidation, China’s real estate crisis may have reached a low point. The Chinese government has authorized a fiscal stimulus package to support infrastructure projects.
Source : X (ex twitter)
However, the Chinese Communist Party has yet to tackle the real estate crisis and the persistent liquidity trap. Overall debt reduction is not appropriate while the economy continues to struggle, with challenges likely to persist for several years. The central bank will keep interest rates low for some time. The yuan should continue to weaken beyond 7.3 against the dollar, despite the PBOC’s efforts to stabilize the currency. The central bank could maintain accommodating liquidity conditions, but is unlikely to resort to aggressive easing. The authorities will take tighter control of lending levers to channel credit to the real economy in line with national strategy, while limiting risks. They are calling for much stricter regulation of banks and local government borrowing. The People’s Bank of China may introduce additional targeted tools, while financial institutions, highly indebted local governments and property developers can expect closer monitoring. We believe that the Chinese economy bottomed out in August-September and will continue to recover in the fourth quarter of 2023. The current economic weakness is due both to a lack of confidence and to structural problems. The authorities obviously do not wish to over-stimulate the economy, but economic prosperity is the key to social stability. The big question is what might become the engine of economic growth in the future. For the time being, this will be more on the fiscal than the monetary front. The recent 1 trillion RMB fiscal stimulus is a positive signal. It should stimulate investment in infrastructure and increase new orders for businesses.
Explanations for China’s economic growth
Sources: Bloomberg, Richelieu Group
Despite the unstable geopolitical situation, relations between the USA and China seem to have improved in recent weeks. However, no one expects a complete return to the pre-2018 situation. The next potential meeting between President Biden and President Xi could lead to certain results. By force of circumstance, China has become the United States’ greatest enemy on all economic, technological and geopolitical fronts. Investors may be tempted to stay away from Chinese equities, but China should be a key strategic allocation in global portfolios.
JAPAN : ATTRACTIVENESS MAINTAINED FOR THE TIME BEING
Japan’s Prime Minister, Fumio Kishida, has announced a major stimulus package worth more than $110 billion, aimed at boosting activity and household consumption. It includes $20 billion in income and residential tax cuts and $10 billion in assistance to low-income households in 2024. The plan is also expected to include subsidies to offset rising oil and electricity prices, as well as a aid to companies to support wage increases. The details of this investment plan, which should be financed by additional public debt, are still lower than in previous years.
As a reminder, the Japanese Prime Minister had already announced a 266 billion euro stimulus package on October 28, 2022, aimed at supporting the Japanese economy in the face of rising inflation and a weak yen. Even if its impact on growth is likely to be modest, it will be likely to encourage sustainably higher inflation (via wages) close to the Bank of Japan’s inflation target, which will contribute to an additional rise in Japanese sovereign yields.
Source : X
At the same time, the Bank of Japan (BoJ) has introduced greater flexibility into its monetary policy of controlling the yield curve. The 1% rate becomes the “reference rate” for the upper bound of the YCC, and the central bank abandons its daily repurchase operations (i.e. no longer sets a firm ceiling at 1%). The decision is accompanied by upward revisions to all inflation projections between 2023 and 2025. This seems to confirm that the plan is to move away from this curve-control policy. With over a trillion dollars in foreign exchange reserves, the BoJ has considerable leverage to deploy and reverse the yen’s depreciation. This should stabilize the yen over the coming months. The Japanese equity market is the best performer in 2023, and remains relatively attractive for the time being, given the government’s commitment to supporting growth. On the corporate side, revisions remain in favor of Japan.
Interest rates
SOVEREIGN BONDS :
In the eurozone, the challenge is to prevent borrowing costs for governments from rising too quickly. Italy, which announced an upwardly revised deficit of 5.3% this year, came under pressure from the markets earlier this month. The good news is that these tensions have not yet spread to other eurozone countries. However, the risk on the yield curve has not really materialized as it has in the United States. We therefore need to limit durations across all bond asset classes in the Eurozone.
10-year yields in major countries
Sources: Bloomberg, Richelieu Group
In the United States, future growth momentum will limit upward pressure on Treasury yields. That said, a further deterioration in labor market conditions is likely to be required for yields to fall significantly. We believe that the US economy could give way to a recession in 2024. The full effect of restrictive monetary policy will be transmitted to the economy, as the first reading of the Atlanta Fed’s GDPNow model already suggests. We remain positive on US sovereign debt. We will increase our positions if rates approach 5%.
The level of interest rates over the years is largely determined by the Fed’s policy stance and market expectations of how it will evolve over the coming year. We believe that 5% could be a peak for 10-year rates, given that the Fed has almost completed its hikes and the trajectory of 1-year rates would remain reversed. Greater visibility on US monetary policy should reduce volatility over the coming months.
INVESTMENT GRADE BONDS : QUALITY REMAINS APPRECIABLE
In the United States, mortgage refinancing risk is low. The average effective residential mortgage rate is 3.6%, with most borrowers fixed for 15-30 years and less than 5% of ARMs due for refinancing in the next 12 months. In commercial real estate (CRE), only 15% of the total market faces this risk over the next twelve months. In IG Credit, only 15% of the index’s total debt will be refinanced in the next two years. Mortgage markets and GI are therefore well insulated from the risk of default. We consider the allocation to US bonds to be attractive, with a gradual increase in the portfolio’s duration.
Investment Grade credit spread
In Europe, interest-rate risk remains more important than spread risk. Rising sovereign interest rates have increased borrowing costs for companies, which could lead to an increase in insolvencies. In this context, we prefer hybrid corporate IG debt, whose step-ups after call dates offer a certain level of protection against rising interest rates. Renewed geopolitical tension has brought euro corporate bond issuance to a standstill, with execution risk and more selective investors.
HIGH-YIELD BONDS : INCREASING RISK
Investors’ reluctance to invest in the riskiest companies was reflected in both the primary and secondary markets. Refinancing conditions for the riskiest companies remain difficult, and growth will be insufficient. The current economic slowdown will not be accompanied by fiscal or monetary measures, which should contribute to a continued rise in corporate default rates. Central banks will not be able to afford to ease financial conditions between now and the end of the year, as underlying inflation will only ease gradually.
Even if central bank rates are set to stabilize, the next tool in the fight against inflation remains liquidity control. High-yield bonds in the front line…
Balance sheets of the main central banks
One third of HY debt is due to mature in the next three years. If the Fed does not cut rates in the coming years, we expect HY defaults to rise to 8-10% in many sectors. Coupons on leveraged loans rose from 4.5% to 9%, and coverage ratios fell one notch to 1.2x. Defaults on leveraged loans and private debt could reach 3%, and 6% if rates remain high.
Valuation of US corporate defaults
Source : X
We’re not in an opportunistic market, as we can sometimes be during periods of renewed volatility, but in a more complex market, where, faced with more cautious and selective investors, issuers must be prepared to make concessions on price to gain access to the market.
In October, like the equity markets, US bond markets faced increasing headwinds, from the vacancy of the Speaker of the House of Representatives to the need for a new US budget resolution and the UAW strike, although economic data tended to surprise on the upside. However, equities can perform well with higher rates, but it’s much trickier on the riskiest debt segments. We favor short bond maturities, with companies benefiting from high cash flows over those whose growth is lagging or who have no earnings today. Credit spreads have widened significantly. We prefer Europe for this segment, which retains better quality springs with appreciable rates of return.
DEVISE
The Fed may consider a pause. The U.S. central bank was attentive, helping to maintain the downward trend in U.S. sovereign interest rates. This time, the press release and Jerome Powell emphasized the marked tightening of financial conditions in recent weeks, which has added to the tightening of credit conditions and strengthened the transmission of monetary policy. This position was perceived as much less ” hawkish ” by investors, who now seem to be turning their attention to the question of how long the pause should last. The Fed now seems to consider that key rates and financial conditions are sufficiently restrictive to fuel disinflation and achieve its objective. However, this will still take time. It should be noted, however, that the President was more satisfied with recent wage trends, which, taking productivity into account, are close to the level compatible with a return of inflation to around 2%. We now believe that the Fed will be able to keep its key rates unchanged for several months in order to encourage slower growth, normalization of the labor market and hence lower inflation, provided that financial conditions do not ease too quickly in the short term. It could then consider a first cut in key rates, towards the end of Q2-2024. Against this backdrop, we expect the dollar’s fall to be gradual.
Currencies against EURO
RAW MATERIALS
Geopolitical tensions abroad led to volatility in equity and commodity markets over the month, while the war in Ukraine entered its second year, and the conflict between Israel and Hamas drove up commodity prices over the month. The Israel-Hamas war would amplify the effects of OPEC’s restrictive policy, supported by Russia, and those of the war in Ukraine. The conflict between Israel and Hamas in Gaza, which began on October 7, 2023, has raised fears of regional escalation. If this happens, the price of a barrel of oil could reach historic highs, with disastrous consequences for the global economy. The World Bank has warned that the price of a barrel of oil could rise to $157 if the conflict flares up. The rise in oil prices is due to several factors.
Sources: The Guardian(click here)
Firstly, a regional conflict would amplify the effects of the restrictive policy of the Organization of the Petroleum Exporting Countries (OPEC), supported by Russia. OPEC cut oil production by 1 million barrels a day in response to the war in Ukraine. It could also lead to disruption of oil and gas infrastructure in the region, and an increase in demand for oil and gas. This could happen if oil and gas importing countries try to protect themselves against supply disruptions.
Such a rise in oil prices would have disastrous consequences for the global economy. It would lead to high inflation, economic recession and increased poverty. If leaders are to take steps to avoid escalating conflict on Israel’s borders, they must also work to reduce the world economy’s dependence on oil and gas.
US production increased, but at a slower pace than in recent cycles, given the number of oil rigs in operation. Oil companies focus on profitability and cash flow.
WTI price versus number of oil rigs in operation
Source : Bloomberg
Even if the worst-case scenario is not the most likely, we believe that oil stocks should be held to guard against it. What’s more, China will make a massive contribution to this growth in consumption, despite recent signs of normalization. US demand is also robust, supported by positive economic data. To repeat, the energy sector should benefit from this situation. This framework could be a further catalyst for the sector, especially with recent dividend increases and share buybacks. However, in recent weeks, Saudi Arabia seems more inclined to talk with the United States which should ” Capper ” boost prices. Our target remains between 80 and 90 USD.
Allocation table
Sources
2 – https://www.nytimes.com/2022/07/21/opinion/paul-krugman-inflation.html
