Who’s the Looser?

Key Points

• While the US overheating is undeniable, it’s difficult to argue there is excess demand in Europe. But this cyclical gap is not replicated in relative financial conditions, which by reference to before the pandemic are not looser in the Euro area than in the US. This is another reason to expect significant policy divergence this year.
• We look into the “exclusion versus engagement” debate which is becoming prominent in sustainable finance.

The issue about inflation in the US now is less about a drift in expectations – surveys paint a reassuring picture on that front – and more about the actual effect of the current overheating. Re-anchoring expectations can often be done by the central bank merely “baring its teeth” but ultimately not doing too much in terms of actual tightening. Curbing excess demand, conversely, entails a proper rise in funding costs of the private sector. Since the Fed has signaled its readiness to reduce its balance sheet faster than during the last normalization phase, mortgage rates have followed the rise in treasury yields. However, corporate bond yields seem to be lagging, remaining more than 1.5 standard deviations below their 2010-2019 average. This asset class normally plays a key role in monetary policy transmission. The Fed may have to toughen up its rhetoric further to get more reaction from that side of the market.

It is much harder to argue that the Euro area is characterized by excess demand, and even with the reasonably brisk growth pace in our forecasts we don’t expect the output gap to close there before the end of this year. However, when taking as reference the pre-pandemic decade, financial conditions are not looser in the Euro area than in the US. This is another reason why we think it’s wrong to qualify the ECB as “being late” relative to the Fed. On top of the cyclical gap between the two regions, there is simply less accommodation to remove in the Euro area than in the US.

The “engagement versus divestment” debate has become prominent in sustainable finance. We review an intriguing academic paper suggesting the current impact of exclusions on capital cost is very limited. While the paper is convincing about the current state of play, we are less sure about the implications for the future, as more pervasive carbon-pricing systems will affect the relative financial performance of highly carbonated businesses. Finally, while in our view engagement – and hence accompanying companies in their transition journey – is key to any successful sustainable investment strategy, divestment can in certain cases be necessary to protect the long-term interests of savers. A business which would not make any effort to adapt to a regulatory environment which is likely to be increasingly tough on environmentally harmful activities is a good candidate to become a “stranded asset”.