Global inflation rates fuelled by supply chain disruption and Russia’s invasion of Ukraine may be close to their peak, offering the US Federal Reserve and Bank of England incentive to level out on policy rates this summer. The European Central Bank, challenged by a monetary union short on economic union and lagging behind in quantitative tightening, will peak later. For the Bank of Japan, after 25 years of adding liquidity, policy rate hikes look remote. Yet rate cuts look off the table till 2024 or later, giving central banks time to gauge labour market reactions and the impact of tightening so far.
OMFIF’s annual asset and risk management seminar convened senior representatives from central banks, economic experts and asset managers to discuss macroeconomic developments and trends in public sector investment management. Participants assessed the impact of stagflation and geopolitics as we emerge from the northern hemisphere winter and looked at the investment landscape for asset and risk management. They also explored portfolio diversification strategies, risk management, financial market stability, environmental, social and governance considerations and long-term sustainable investment opportunities.
At last year’s event, less than three weeks after Russia’s invasion, David Marsh, OMFIF chairman, highlighted the ‘hot war in Europe’ as being the most significant since 1945. Respondents to OMFIF’s Global Public Investor 2022 survey cited stagflation and geopolitical risk as their main investment concerns.
At the 2023 seminar, participants considered these factors to be dominant still in reserve management and portfolio strategy. Despite modest upgrades to growth forecasts as we emerge from a relatively mild winter, most economies were ‘not out of the woods’. Vulnerable regions understandably include eastern Europe (Ukraine’s gross domestic product was expected to only broadly stabilise in 2023 after a 30% fall in 2022), while central Asia looked to be supported by commodity exports and remittance inflows, not least from Russia.
High food and fuel prices continued to bloat emerging markets’ inflation rates, but with many of them having lived through high inflation in the 1990s, emerging markets may now be in better position than many developed economies to control it. One concerning observation was the step up in exports to Russia seen in countries including Armenia, Georgia and Kazakhstan of intermediate and capital goods they had imported from Germany. These were some of the few countries globally showing real wage growth. The risk of secondary sanctions is therefore looming.
For developed economies, the era of quiet is over for inflation volatility with subsequent policy effects on growth. Seldom since 1945 have major economies experienced sustained disinflation without recession, though comparing the ‘new normal’ of negative real rates and inequality partly induced by over a decade of quantitative easing was unfair. The legacy of this is excessively high government debt ratios and swollen central bank balance sheets, meaning it’s in policy-makers interests to limit rate and bond yield rises. This sets it apart from previous tightening cycles.
Other concerns include default risks from sovereigns and corporates with excessive external debt obligations, and a rise in European Union bankruptcies, which remain only about 40% of pre-Covid-19 levels. Any pressure to finance weak corporates falls on state banks. Russia’s hurt in 2022 was limited by an only 3.4% year-on-year GDP fall, and this could be offset in 2023. But it was not anticipating its assets to be frozen. The impact remains to be seen, but there’s scepticism that the dollar would lose its king currency status, not least to the renminbi.
Comforts for reserve managers include the relatively stable banking sector, and a more conservative search for yield via super national names. But duration risk was a concern in trying to keep debt service costs down, as were central banks’ capital positions as foreign exchange reserves are used to maintain currencies. The resulting undercapitalisation could take years to reclaim. This makes it difficult for their risk assessment committees to plan longer-term allocations.
The participants at the seminar warned against putting returns ahead of liquidity and ‘doubling up’ on risk to quickly patch up capital positions. Though not a short-term problem, it was difficult to see how portfolio decisions could be made if ‘huge losses’ are extended over time.
Credit was given to the Bank of England and ECB’s so far ‘impressive’ market communication on QT. This would need to continue if asset markets are to absorb without disruption the bonds coming back onto the market: by starting QE in 2009 the BoE has gone from ‘supporting the market to being the market’. Meanwhile, short-term losses on QT (equivalent for the Fed to up to 5% of GDP, for the BoE 10%) put pressure on central banks’ balance sheets. If reserve managers could have apportioned their excess reserves into a sovereign fund, this may have helped matters.
So, there’s much to look out for in OMFIF’s forthcoming survey of central bank reserve managers, not least whether their optimism is buoyed as we emerge from the winter amid hopes that US and UK policy will peak and that stagflation starts to ease. Will the shine come off gold and the dollar? Or will central banks follow the lead of pension and sovereign fund managers surveyed in late 2022 and signal risk off sentiment and more conservative strategies?
Neil Williams is Chief Economist of OMFIF.