The year 2022 could well mark an important paradigm shift for financial markets: the end of the idyllic scenario of inflation-free growth and the beginning of an era of stagflation. Stagnant growth coupled with galloping inflation? Investment management will have to be adapted accordingly…
A headache for central banks
Since 2009, markets have benefited from the dream macroeconomic framework of robust economic growth that allowed companies to generate profits, coupled with largely non- existent inflation that gave central banks a blank check to inject large amounts of liquidity when needed, such as during the Eurozone debt crisis in 2011 or the pandemic crisis in 2020. It is not surprising that this “Goldilocks” scenario (an economy that is “neither too hot, nor too cold, just right”) has allowed the US stock market to grow sixfold in value since 2009.
The year 2022 is likely to mark the end of the fairy tale and the beginning of a period of stagflation, i.e. stagnant growth coupled with strong inflation. Economic paradigm shift in 2022?
Stagflation may well prove to be a headache for central banks. Faced with the new variant of the Omicron, which is likely to reignite fears of a slowdown in growth, central banks could quickly find themselves in a dilemma: should they ease monetary policy again to ensure that the slowdown does not turn into a recession, or put both feet on the brake to prevent inflation from taking off?
The markets are anticipating two or even three rate hikes by the US central bank. Its President, Jerome Powell, is currently on the side of the hawks, who make the fight against inflation a priority. It’s true that looking at the evolution of the latter, there is reason to be alarmed.
In the US, the Fed wants to fight inflation
However, we believe that the Fed should act with moderation in its fight against the rising general price level, for at least three reasons. First, the U.S. central bank will want to avoid at all costs the “tantrum” that bond investors showed when former Fed Chairman Jerome Powell indicated in 2013 that the central bank would reduce liquidity injections. Bond yields literally soared. Today, the much larger debt load of the U.S. government does not allow for this kind of slippage. Second, inflation is primarily related to increased costs, which in turn are caused by bottlenecks and other supply chain impediments caused by the pandemic. These should gradually be resolved by the summer of next year, and inflationary pressures with them. The third reason is that a central bank should not tighten monetary policy when faced with a cost-push inflation problem. Only when inflation is caused by excess demand typical of an overheating economy are interest rate hikes justified. As an illustration, Brazil has just entered a recession, while inflation is over 10%. Faced with this stagflation, the Central Bank has massively raised its key rates. While this increase could help Brazil strengthen its currency and fight imported inflation at the same time, a good part of the price increase is caused by the worst drought Brazil has experienced in a century: it is hard to see what interest rate hikes can do against this kind of phenomenon.
If there is one currency that does not need central bank support, it is the franc.
Could the Swiss franc be undervalued!?
We have been waiting for a long time for this moment when we could say that the franc is undervalued … Yes, you read that right! Since November, any appreciation of the franc is fundamentally justified! Against the euro, that is. We estimate the fair value of the franc at 1.01 francs for one euro. Here is why.
The only tool at our disposal to estimate the fundamental value of a currency in relation to the exchange rates of its trading partners is the “Purchasing Power Parity” (PPP). In concrete terms, the fair value of a currency tends to appreciate if foreign inflation increases faster than domestic inflation. This is the case when comparing inflation in Switzerland and in the Eurozone. At the height of the pandemic in 2020, producer prices fell by 5% in the Eurozone, compared to only 2.5% in Switzerland. Today, these same prices are rising by 16% in our European neighbors, compared to only 3% in Switzerland. It is therefore justified that the equilibrium value of the franc appreciates by the difference, i.e. 13% over the last 12 months. This inflation differential is in fact the slope of the orange curve on the graph. It is this curve that gives the theoretical value of the franc which balances the purchasing power in the Euro zone and in Switzerland. Since the creation of the euro, the slope has been negative: the continuous fall of the PPP curve shows a more marked inflation in the Euro zone, justifying an appreciation of the franc. Over the past year, the sharp increase in producer prices in the euro zone has caused the PPP curve to fall below the red curve indicating the current exchange rate of the franc against the euro. At 1.04 for the latter, against 1.01 for the PPP, the franc is therefore now officially undervalued, albeit only slightly.
The Frank is no longer overvalued!
The Swiss National Bank has not yet changed the key word that all currency traders look at to estimate the degree of intervention in the currency market. Until 2017, the SNB saw the franc as “clearly overvalued.” Since September 2017, it has referred to the franc as “highly valued.” Let’s bet that the next label it will stick on its currency will be “balanced”.
How can we justify the franc’s rise against the euro? For its equilibrium value, we have just seen that it is the higher inflation in the Euro zone that justifies the appreciation of the franc. And this inflation differential is also an indirect cause of the rise of the franc against the euro observed on the markets. More to the point, one of the main reasons why investors are buying the Swiss franc is the interest rate differential, both in the short and long term. The SNB has long believed that lowering short- term interest rates in Switzerland is enough to weaken the franc against the euro. This is what led the SNB to declare that these interest rates would be negative as of December 2014. Except that this policy has hardly been effective in curbing the rise of the franc. We see two reasons for this: the first is that the franc is a safe haven. When investors fear that the debt crisis in the Eurozone will result in an implosion of the European currency, they rush to the franc, and a negative yield of 0.75% will not deter them. On the other hand, and most importantly, it is not the nominal interest rates that count, but the real returns! Once you take inflation into account, the difference between the yields in the eurozone and those in Switzerland is largely negative: it has never been so negative since the euro was created in 2000. No wonder the franc has risen once again, and has fallen below the unofficial floor of 1.05 francs to the euro.
What’s next? We would not be surprised if the franc again teases parity against the euro. The European currency is suffering from the monetization of government debt by the European Central Bank. Let’s take the example of Greece: at the time of the debt crisis in 2010, its public debt reached 170% of gross domestic product. Today, it is 220% of its GDP! In our view, the only reason that Greece has fallen off investors’ radars is that the cost of this debt – 10-year bond yields – is at 1.2%, compared to over 40% at the height of the debt crisis in 2012. And this is thanks to the ECB’s untimely purchases of sovereign bonds issued by Eurozone countries. The same goes for other heavily indebted Eurozone countries, such as Italy. The currency market is not fooled: a country that runs its money printing presses at all costs to help the state has little chance of seeing its currency appreciate.
Implications for our investment policy
While we remain convinced that central banks will not be able to fully address inflationary pressures around the world, 2022 will likely mark an era of more moderate growth, higher inflation and less liquidity injections by central banks. In an environment where equity market valuations remain generally high, our investment policy for 2022 will be cautious.
On the currency side, we still expect the dollar to strengthen more against the euro than against the Swiss franc, due to the Fed’s primacy in tightening monetary policy.
Dr Michel Girardin Chief Economist
Professor of Macro-Finance
University of Geneva
© JAR Group, 2020