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Inflation debate looms large over US market outlook



In a year replete with striking developments, one critical signal by the US Federal Reserve should not be overlooked by investors.

In a late August speech, Fed chair Jay Powell outlined a new approach by the central bank to tolerate a pace of inflation above its current target of 2 per cent in the coming years.

With US inflation running at 1.2 per cent, it might seem a moot point in the near term. But Fed acceptance of a more inflationary world has intensified a debate in the markets. How long will the central bank continue its extraordinary run of bond buying to keep interest rates down and support the economy in an effort to push inflation higher?

Investors have a lot at stake. Owners of bonds will suffer losses if higher inflation erodes the value of the low, fixed interest rates on their holdings over time. Equity markets might not escape either, with the need for a bigger premium to compensate for higher inflation risk likely to test richly valued shares.

“People are so accustomed to the idea that inflation is not going anywhere and markets are very complacent. That means a big dislocation in rates and markets when investors lose confidence in that view,” said David Bianco, chief investment officer in the Americas for DWS, the asset manager. “It’s not just the bond market that is dependent on low interest rates.”

Already, market expectations of inflation are on the rise as the global economy pulls out of 2020’s shock on the back of enormous fiscal and monetary stimulus. In the US, long-term inflation expectations implied by the bond market have rebounded sharply from pandemic lows to their highest in 18 months.

These expectations are only back at their average of 1.9 per cent seen for the past decade, according to Bloomberg data. However, if the Fed keeps suppressing yields, inflation expectations can rise more.

Massive purchases of government debt this year have resulted in nominal Treasury yields significantly lagging behind rebounding inflation expectations. A US 10-year yield shy of 1 per cent has only picked up from a low of 0.5 per cent earlier this year. In contrast, 10-year inflation expectations for the next decade have jumped from 0.55 per cent in March to 1.9 per cent.

The divergence between these two measures has kept real yields — interest rates that strip out inflation from nominal returns — stuck well below zero. A negative real rate occurs when inflation runs above nominal yields.

Line chart of US real 10-year bond yield and implied inflation expectations (%)  showing negative real yields reflect easy financial conditions

Negative real yields matter because they facilitate loose financial conditions. That kind of environment is very fertile for risky assets such as equities, while it tends to sap the dollar’s strength.

These trends are in full force at the moment and will probably continue, because the last thing the Fed wants is a reversal of loose financial conditions. That could lead to a sharp pullback in equities alongside a stronger dollar, both of which would act as disinflationary forces.

Backing the Fed’s new approach is a view that the damage inflicted upon global activity by the pandemic is such that restoring full levels of employment will take several years. Entrenched secular forces of ageing populations, innovative technology and the global sourcing of labour and capital are disinflationary in nature and not seen as fading.

The upshot is more central bank buying of bonds in order to prevent a sharp climb in long-term interest rates while tolerating more inflation.

This all explains why so many investors are bearish on the US dollar, the global reserve currency. However, a weaker dollar in turn boosts commodity prices, an important driver of inflation expectations, while it raises the cost of imported goods for US consumers and companies.

“The real story is about 2022 and beyond,” reckons Steven Blitz, chief US economist at TS Lombard. A broader economic recovery and a push for higher minimum wages should be well established by then and test the Fed’s willingness to let the economy run hot.

But it may be too late for the Fed to start raising rates and stop inflation if investors and the broader public believe rising prices are coming back in a big way. This is where the current policy objectives could work too well, pushing inflation expectations up and persuading investors and consumers that a tipping point has been reached.

A logical response would be a rush for loans in order to buy assets that gain in value from a more reflationary environment, such as gold and real estate. And — thanks to the ballooning central bank balance sheet — there are plenty of excess reserves held at the Fed by financial lenders that could feed a surge in loan demand.

For now, bank reserves created by central bank bond purchases are described as “cold money” by Mr Bianco: they sit in the financial system and are not being lent out into the broader economy. However, Mr Bianco says these reserves could become a lot hotter should “more cash enter the economy via a big rise in loan growth”. He worries: “Once that starts and feeds on itself, the inflation genie is out of the bottle.”


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Andrew Yang; Facebook; WallStreet Bets and much more . . . 

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A carbon registry leaves polluters with nowhere left to hide




The writer is the founder and executive chair of the Carbon Tracker Initiative, a think-tank

No one yet knows which countries will extract the last barrel of oil, therm of gas or seam of coal. But the jostling has started. Every nation has reasons to believe it has the “right” to continue fossil fuel extraction, leaving others to deal with the climate crisis.

In the Middle East, oil producers can argue that the cost of extraction is low. In Canada, they market their human rights record. Norwegians trumpet the low-carbon intensity of their operations. And in the US under Donald Trump, they touted the virtues of “freedom gas” and called exports of liquefied natural gas “molecules of freedom”.

The dilemma for governments is that if one country stops producing fossil fuels domestically, others will step in to take market share. And so the obligation to contain emissions set out in the Paris Agreement risks being undermined by special pleading.

In the UK, the furore over plans for a new coal mine in Cumbria the year that the country is hosting the UN’s climate summit is indicative of the contrary positions many countries hold. Facing one way the government says it is addressing climate change. But looking the other, it consents not just to continued extraction, but to support and subsidise the expansion of production.

Climate Capital

Where climate change meets business, markets and politics. Explore the FT’s coverage here 

To keep warming under the Paris Agreement limit of 1.5C, countries need to decrease production of oil, gas and coal by 6 per cent a year for the next decade. Worryingly, they are instead planning increases of 2 per cent annually, the UN says. On this course, by 2030 production will be too high to keep temperature rises below 1.5C. The climate maths just doesn’t work.

One of the problems in attempting to track fossil-fuel production is the lack of transparency by both governments and corporations over how much CO2 is embedded in reserves likely to be developed. This makes it difficult to determine how to use the last of the world’s “carbon budget” before temperature thresholds such as 1.5C are exceeded.

Governments need a tool that establishes the extent to which business as usual overshoots their “allowance” of carbon. There needs to be a corrective because the cost competitiveness of renewable energy, and the risk of stranded energy assets, has not stopped governments heavily subsidising fossil fuels. During the pandemic, stimulus dollars have been dumped into the fossil-fuel sector regardless of its steady financial decline, staggering mounds of debt and falling job count. 

This is why my initiative and Global Energy Monitor, a non-profit group, are developing a global registry of fossil fuels, a publicly available database of all reserves in the ground and in production. This will allow governments, investors, researchers and civil society organisations, including the public, to assess the amount of embedded CO2 in coal, oil and gas projects globally. It will be a standalone tool and can provide a model for a potential UN-hosted registry.

With it, producer nations will have nowhere left to hide. It will help counter the absence of mechanisms in the UN’s climate change convention to restrain national beggar-thy-neighbour expansion of fossil-fuel production.

No country, community or company can go it alone. But governments can draw from the lessons of nuclear non-proliferation. First, they must stop adding to the problem; exploration and expansion into new reserves must end. This must be accompanied by “global disarmament” — using up stockpiles and ceasing production. Finally, access to renewable energy and low-carbon solutions must be developed in comprehensive and equitable transition plans.

The choice is between phasing out fossil fuels and fast-tracking low-carbon solutions, or locking-in economic, health and climate catastrophe. A fossil-fuel registry will help governments and international organisations plan for the low-carbon world ahead.

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Hasty, imperfect ESG is not the path for business




The writer is a global economist. Her book ‘How Boards Work’ will be published in May

Good environmental, social and governance practices take a company from financial shareholder maximisation to multiple stakeholder optimisation: society, community, employees. But if done poorly, not only does ESG miss its sustainability goals, it can make things worse and let down the very stakeholders it should help.

To be sure, the ESG agenda should be pursued with determination. But there are a number of reasons why it threatens to create bad outcomes. The agenda is putting companies on the defensive. From boardrooms, I have seen organisations worry about meeting the demands of environmental and social justice activists, leading to risk aversion in allocating capital. Yet innovation is the most important tool to address many of the challenges of climate change, inequality and social discord.

Pursued by $45tn of investments, using the broadest classification, ESG is weighed down by inconsistent, blurry metrics. Investors and lobbyists use different evaluation standards and goals, which focus on varied issues such as CO2 emissions and diversity. Metrics also depend on business models.

Without a clear, unified compass, companies that measure themselves against today’s standards risk seeming off base once a more consistent regulator-led direction emerges (for example, from worker audits, the COP26 summit and the Paris Club lender nations).

ESG is not without cost and the best hope for long-term success lies with business leaders’ ability to stay attuned to its impact and unintended consequences. For example, while the case for diversity is incontrovertible, efforts at inclusion should account for the possible casualties of positive discrimination.

Furthermore, despite ESG advocates setting a strong and singular direction for governance, organisations have to maintain their operations and value while managing assets and people in a world where cultural and ethical values are far from universal. While laudable, a heightened focus on ethics (such as human rights, environmental concerns, gender and racial parity, data privacy and worker advocacy) places additional stress on global companies.

It is often asked if advocates appreciate that ESG is largely viewed from the west’s narrow and wealthy economic perspective. To be truly sustainable, ESG demands global solutions to global problems. Proposals need to be scalable, exportable and palatable to emerging countries like India and China, or no effort will truly move the needle.

Much of the agenda is too rigid, requires aggressive timelines and lacks the spirit of innovation to achieve long-term societal progress. Stakeholders’ interests differ, so ESG solutions must be nuanced, balanced and trade off speed of implementation against the breadth and depth of change.

Business leaders are aware of the need for greater focus and prioritisation of ESG. We also understand that deadlines can provide important levers for senior managers to spur their organisations into action. After all, in the face of pressure for a solution to the global pandemic, vaccines were produced in months instead of the usual 10 years.

I live at the crossroads of these tensions every day. Raised in Africa, I have lived in energy poverty, and seen how it continues to impede living standards globally. As a board member of a global energy company, I have seen much investment in the energy transition. Yet from my role with a university endowment, I have also been under pressure to divest from energy corporations. 

Business leaders must solve ESG concerns in ways that do not set corporations on a path to failure in the long term. They must have the boldness to adopt a flexible, measured and experimental agenda for lasting change. In this sense, they must push back against the politically led narrative that wants imperfect ESG changes at any cost.

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