PI Partnership – Jupiter Asset Management
the situation worse, creating tight labour markets. Labour is suffering from weak- ened post-Covid health services, tighter immigration
policies and, for demo-
Mark Nash is fixed income investment manager focused on absolute return at Jupiter Asset Management
GOVERNMENTS PUT THEIR BOND MARKETS IN THE FIRING LINE
The fluid macro environment during 2022 has been an excellent playing field for macro investors as the shifts in sov- ereign fundamentals have not been this aggressive since before the financial cri- sis. Amidst all the volatility, there has been defined macro regimes producing market trends that flexible portfolios can capture. However, to be successful, portfolio con- structs have had to change and adapt as the market’s views on growth and infla- tion have not remained static. The pressure facing developed market economies in 2022 has come from exter- nal and internal sources. The sanctions that followed Russia’s invasion of Ukraine has excluded the largest fuel producer from the global economy and has heralded a new era of expensive and inelastic global energy markets. It marks a big shift towards the end of glo- balisation as cheap and easily accessible energy is not available anymore. Expen- sive energy hitting strong economies drove inflation higher and trade balances lower for those without adequate domes- tic energy resources. Looking more broadly, expensive global resources appear permanent, as a lack of invest- ment in recent decades in resource extrac- tion and energy infrastructure and the green transition compound problems. A shortage of labour in the West has made
12 | portfolio institutional | November 2022 | Issue 118
graphic reasons, more retirees. In conjunction with expensive energy the wage/price spiral risks are real. As goods prices have eased back in recent months on the back of improving supply chains, services prices have boomed as economies re-open. This classic macro imbalance drove a singular response from central banks: to crush demand.
The weaker growth this produced com- bined with deteriorating trade balances for developed market commodity import- ers and the ‘cost crisis’ meant currency markets took the strain, as expensive imports damaged private sector balance sheets. Whilst the move in currency mar- kets favoured the resource rich econo- mies, the sell-off in the bond market was not on firm ground.
The high inflation levels reached over the summer morphed into intense recession risks as high prices destroyed consumer and business confidence. Commodity markets also succumbed to weaker growth providing some welcome relief. However, as the Ukrainian conflict inten- sified, and energy became weaponised, global energy prices fractured with Euro- pean natural gas prices surging as oil fell. As recession concerns grew, global bond markets staged an impressive recovery over the summer months. Whilst central banks secretly enjoyed this demand destruction, governments were not pleased. The recent fiscal spending announce- ments to support economies changed the market calculus dramatically. As govern- ments took the problem onto their bal- ance sheets stimulating the private sec- tor, inflation once again became front and centre. This shifted the strain from foreign exchange to the bond markets, resulting in a dramatic bond sell off in recent weeks. Bond investors need higher returns to fund governments and support this new
policy mix at a time demand needs to fall, not rise. Central banks need to counter this by getting policy rates higher. In the UK, the fiscal injection was untargeted and stimulatory at a time inflation hov- ered above 10%. With the central bank ret- icent to hike, sovereign risk rose as the gilt market, led by the long end, came under serious pressure. The UK might have the highest external funding needs but it’s also a window into what is impacting all energy importing economies. Poorly con- structed fiscal policy working against cen- tral bank actions is clearly not a good mix for the sovereign bond markets. This opens a new chapter for markets in 2022, one in which financial risks are now a problem, alongside the existing inflationary supply and demand imbal- ance. European governments are now writing blank cheques to cover energy costs dragging their own fiscal balances into the firing line. Sensible government policy has never been so vital. Whereas higher energy had a weakening impact on private sector demand previously, it does not have the same effect now, as govern- ments absorb the cost.
If energy prices move higher still, to keep the confidence of the markets tighter cen- tral bank policy and government austerity measures will be needed. If this doesn’t happen, inflation will not come under control and reliance on external funding sources will intensify. This will prove dif- ficult for some policymakers given the hardship this imposes on the wider popu- lation. Markets will force borrowing costs higher to make sure central banks and governments respond adequately. This is also where the US could get dragged down by European problems. As often is the case in a financial crisis, the globally connected financial system trans- mits problems across the globe. A deterioration of European sovereign risk will likely see a scramble for US dol- lars everywhere to pay for expensive energy and in some cases intervention in domestic currencies. Either scenario will
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