Friday 10th September, 2021
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Equities have been on a downwards path for much of this week as concerns grow among investors that US and European central banks will soon begin to taper their massive asset purchase programmes in response to consumer price inflation and tighter labour market conditions. The unprecedented liquidity bonanza that has taken place over the past 18 months has propelled markets to record highs at a time of profound economic uncertainty the world over. It is no wonder, therefore, that the prospect of this policy support being withdrawn (albeit very gradually) is causing market jitters. Over the first four days of this week, and ahead of the Friday morning open in the US, the S&P 500 Index was down -0.9% and the MSCI Emerging Market Index was down -1.2% (in USD). Meanwhile, the Euro STOXX 600 Index was down -0.9%. There has since been a modest bounce in European equities this morning, but indices are still lower for the week overall. As ever, whether this drawdown is the beginning of a more sustained correction or just another shallow dip is impossible to forecast, but policymakers will have to tread a fine line if they want to avoid a taper tantrum in the months ahead.
The President of the European Central Bank (ECB), Christine Lagarde, was doing just that on Thursday when she announced a slight reduction in the pace of the ECB’s Pandemic Emergency Purchase Programme (PEPP) over the next quarter. Although Lagarde did not herself quantify the stimulus cut in her speech, sources close to the ECB’s Governing Council told reporters that the central bank will go from buying EUR 80bn of bonds each month to EUR 60-70bn (albeit with flexibility to adjust purchases based on prevailing financial conditions). President Lagarde was keen to stress that no decision has been taken regarding the right level of asset purchases beyond this initial three-month period, and that investors should not interpret the re-calibration of the PEPP as the start of a sustained tightening cycle. “The lady isn’t tapering” Lagarde said – while tapering. A consummate politician if we ever saw one!
President Lagarde’s speech has been positive for risk assets so far, as investors focus on her dovish tone and ambiguous guidance more than on the actual policy change. European equities are up, and peripheral spreads have narrowed sharply in response. This is because Eurozone consumer inflation hit 3% at the end of August, and many market participants were positioned for a more hawkish posture from the ECB going into Q4. However, in the end, the ECB’s decision to taper without admitting it seems to have struck the right balance in the era of Fake News and alternative facts.
To be sure, it makes sense for the ECB to play it cool on QE withdrawal. Afterall, much of the world is still struggling to contain the pandemic (not least the US, which now has the highest rate of covid-19 hospitalisations since January). In addition, the highly infectious Delta variant has by no means been defeated on the continent and winter is coming. Recent UK data shows that when Delta is circulating at a high level (as it will across Europe throughout the winter) aggressive contact tracing can have a large negative impact on economic activity. The so-called ‘ping-demic’ of extended self-isolation for close contacts of those testing positive for covid-19 caused UK growth to slow to just 0.1% in July! The key to managing any surge in cases this winter is clearly to vaccinate as many people as possible in the run-up to Christmas; and that is not something over which Lagarde et al. have any control.
One thing that does seem certain to us is that the ECB will be in no rush to raise interest rates any time soon, whatever the pace of QE tapering. European government debts have ballooned unsustainably during the pandemic, with the sclerotic economies of Southern Europe being the worst affected. Inflation would undoubtedly have negative effects on household finances and many businesses, but a decline in the real value of outstanding government liabilities is an obvious silver lining. This is one reason we have long favoured an allocation to commodities – and precious metals in particular. Inflation could well run hot for some time before central banks turn the screws on rates.
Across the Atlantic this week, politicians from another country with a vast national debt – the US – are currently wrangling over how much to increase it by; and investors are watching very closely. President Biden has backed a 100% partisan USD 3.5tn social spending package which is focused on childcare, education, climate change, and health, but the bill is now stuck in Congress amid Democratic divisions over the enormous price tag. Joe Manchin, a centrist senator from West Virginia, appears to have the deciding vote in a chamber which splits 50-50 along party lines – and he wants big changes before he agrees to cast that vote for any more government spending. On the other side of the debate, are Bernie Sanders and a group of progressives who are operating a scorched earth policy of threatening to derail the USD 1.2tn infrastructure bill that won broad support last month. If the Democrats can compromise, markets will get a welcome boost this Autumn; and we anticipate that some sort of deal is coming. But in the hyper-partisan atmosphere of Washington DC anything is possible.
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