Cooling Inflation
January 18
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Here are some of the biggest stories from last week:
Dig deeper into these stories in this week’s review.
In welcome news to the new British government, fresh data this week showed the UK economy expanded by 0.4% in May from the month before – double the pace expected. Helping matters was good weather, which revived the services and construction sectors after heavy rain held back activity in April and caused the economy to flatline. The latest figures mean that UK GDP has risen by 0.9% in the three months to May compared to the previous three – the quickest pace in more than two years and better than the Bank of England had anticipated. However, the strong showing may also make the central bank more hesitant to start cutting interest rates, especially with some policymakers warning that inflation is expected to pick up in the second half of the year.
Across the pond, all eyes were on the latest US consumer prices report, which showed the annual pace of inflation ticking down to 3% in June from 3.3% the month one. That was slightly lower than what economists were expecting, and marked the slowest pace of price gains since March 2021. Core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, dipped slightly to 3.3%, defying forecasts for an unchanged reading. On a month-over-month basis, consumer prices fell by 0.1%, marking the first decrease since 2020, while core prices increased by 0.1%. Both figures came in below expectations and could prompt the Fed to begin reducing interest rates soon, with traders upping their bets for the first cut to come in September after the release.
Issuance of green, social, sustainable, and sustainability-linked bonds rose 15% in the first three months of the year compared to the same period in 2023, hitting $272.7 billion – the most ever issued in a single quarter. More than 70% of the proceeds were from green bonds, which are issued by companies, organizations, and governments to fund environmentally friendly projects. These instruments have been proving to be popular with an increasingly eco-minded investor base, with the cumulative amount issued since 2006 crossing the $3 trillion mark for the first time last quarter.
Like conventional fixed income, demand for sustainable debt has been buoyed by higher interest rates. But it has also been supported by what some analysts describe as an erosion in the "greenium" – a discount in the cost of borrowing that green bond issuers typically benefit from. This means that, in many cases, investors can put money into sustainable debt without sacrificing much, if anything, in terms of yield.
While there are several drivers behind the erosion, the biggest is the huge increase in issuance over the past few years. See, as more green bonds enter the market, the scarcity value of these unique instruments shrinks, reducing the premium that investors are willing to pay for the bonds. And this surge in supply is showing no signs of slowing down, with the Climate Bonds Initiative predicting that green bond issuance is on track to hit a total of $1 trillion this year.
During the 2015 Paris Accord, countries agreed to limit global temperature rises to “well below” 2C and “ideally” to 1.5C compared to pre-industrial levels. However, the planet has now hit or exceeded that threshold for 12 months in a row. More specifically, the global average temperature for the year through June 2024 was 1.64C above the pre-industrial baseline, according to a report this week by the Copernicus Climate Change Service. That’s not entirely surprising when you consider that June marked the 13th month in a row that temperatures were the warmest on record. But it’s not all doom and gloom, with scientists quick to emphasize that the breach doesn’t mean a failure to uphold the Paris Accord, which is based on a longer-term temperature increase of more than a decade.
However, the breach has intensified calls for quicker and more decisive action to combat rising global temperatures. This has big implications for companies, which are likely to see surging financial costs over the coming decades due to the physical impacts of climate change. Without adaptation measures, these costs will average 3.2% per year of the value of real assets held by firms in the S&P 500 by the 2050s, according to the index provider. These costs are annual and cumulative over time, representing a material financial risk for many companies. Most exposed is the communication services sector – especially firms that own and operate data centers, which are proving essential for the increasingly digital economy. After all, these assets are very sensitive to extreme temperatures and restricted water access due to their heavy cooling needs.
Leveraged lending refers to the practice of providing loans to companies that already have considerable amounts of debt or have a higher risk of default. This type of credit is an important source of funding for the private equity (PE) sector, with nearly three-quarters of leveraged loans globally linked to companies backed by PE.
But there are growing signs that more and more of these firms are struggling under the burden of higher interest rates. Global default rates on leveraged loans have more than tripled, from around 2% in early 2022 to roughly 7% today, according to the Bank of England’s biannual Financial Stability Report. That’s above the long-term average, although still below the peak of 12% hit during the global financial crisis.
These growing challenges present risks to PE investors, banks, and the wider economy, the BoE warned. In a higher-rate environment, increased financing costs dent the performance of heavily indebted PE-owned firms and, ultimately, PE funds. What’s more, rising borrowing costs have led to a sharp slowdown in dealmaking activity, which has made it more challenging for PE firms to exit their investments. In fact, Bain estimates that a record-breaking 28,000 unsold companies – worth more than $3 trillion – were in the clutches of the world’s PE groups at the end of last year.
More broadly, the global banking system has significant exposure to the PE sector, and the surge in defaults has led to increasing credit losses for the banks. Also, the lack of transparency about these exposures, which often consist of multiple layers of leverage, could prompt banks to reduce their risk-taking activities and cut back on overall lending more than necessary. That’s not good news. Credit, after all, is the lifeblood of the economy: when it gets harder to borrow, consumers spend less and businesses invest less, hobbling economic growth and increasing the odds of a recession…
General Disclaimer
This content is for informational purposes only and does not constitute financial advice or a recommendation to buy or sell. Investments carry risks, including the potential loss of capital. Past performance is not indicative of future results. Before making investment decisions, consider your financial objectives or consult a qualified financial advisor.
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