After the Pandemic, the Rate Hike Stranglehold

The Covid-19 pandemic hasn’t quite gone away yet and the global economy faces several headwinds going forward into the rest of this year and the next. Some of it is due to the hangover effects of the pandemic and others due to new challenges arising out of those.

The main challenges to global economic growth – and of course, this varies from region to region and country to country – are soaring inflation, rising interest rates and the already high levels of debt across the world. Consumer price inflation has been raging for almost a year now both across developed economies and developing and emerging economies. In the US and UK, CPI hit 9.1% and 9.4% respectively in June 2022, while in the Eurozone, it was 8.6% and 7.01% in India. This, with central banks already raising interest rates to combat high inflation. The main culprits are high oil and energy prices, as well as supply chain shortages, of course. But even looking at the core CPI, it appears that inflation is now broad-based and well-entrenched. In Western economies, it’s the surge in post-lockdown demand with supply still adjusting to it, and higher wages that are driving inflation

Core CPI in India, for example, has been stubborn at around 6% for a year. And here, it is mainly due to high commodity prices, much of which we import, as well as high domestic fuel prices, thanks to government policy. China seems to be the only country not experiencing high inflation – which may be due to its particular CPI composition – and with the slowdown in the Chinese economy thanks to lockdowns and zero-Covid policy, it appears that inflation will stay muted in the near future. In recent weeks it is being reported that many commodity prices are cooling off, but with China having eased its lockdowns and with the war in Ukraine still raging, there is no saying if they are likely to come down any further.

The US Federal Reserve, the Bank of England and RBI had already begun their rate hike cycle earlier this year, and the ECB has announced its first interest rate increase in 11 years, just last week. The slight lag in Europe is due to the slightly different inflation environment there, I suppose, with high energy and fuel costs being the main cause of it. One is not sure how much an interest rate hike will help there, though the ECB is said to be trying out a new monetary policy tool this time that is meant to keep the effect of the rate increase uniform across member countries.

While central banks are required to fight inflation and raise interest rates, their actions are likely to hurt the economy in several ways, which is why central banks have to carefully calibrate – and coordinate – their rate increases. The first effect will be seen on consumer demand, since that is what rate hikes are meant to do. It is a double-whammy of course, since inflation had already been weakening consumer demand, especially in lower-income consumer segments of the market, added to which we now have interest rate hikes. And in countries like India, where there was no fiscal stimulus to household incomes the way there was in the West, consumer demand surged only ever so slightly post the lockdowns in 2020 lasting up to the second wave of Covid in March 2021 which was widespread in the country.

In the US and perhaps even in the UK, the first impact of the rate hikes was seen in the housing market, where inflation had already dampened demand, and rate hikes have seen mortgage applications fall even more sharply. But more importantly, they will adversely affect the corporate earnings of multinational companies, especially in the US. The mere expectation of a rate hike had already strengthened the US dollar, which has now risen to record highs in response to the rate hikes. Almost every currency has weakened against the US dollar, with the Japanese Yen weakening the most at 21% since the start of this year. The Euro is at parity with the US dollar, which hasn’t been seen in decades, and the British pound too has weakened significantly.

While a weaker euro and pound ought to help Eurozone countries and Britain boost their exports and improve their multinationals’ corporate earnings, so much of it also depends on consumer demand in China, the largest market for many of them. Besides, the pressure from the war in Ukraine which shows no signs of abating is pressuring European countries to step in and save their energy utilities. It has been reported that Germany’s government is taking a large stake in utility giant, Uniper, thanks to a steep fall in gas imports via Nordstream 1 affecting its operations. Meanwhile in France, the French government is having to nationalise EDF, its largest electricity company. In volatile and uncertain economic times like these, governments might once again get bigger, having to even bail out companies. Flash PMIs for France and Germany, Europe’s biggest economies were both indicating a contraction in July, along with a slowdown in the UK. Germany’s business sentiment index from IFO is also at a lower level. One doesn’t know if lower consumer spending owing to inflation, will be accompanied by lower production in Europe due to energy shortages at later date.  

Higher inflation is affecting consumers’ spending patterns; Image: Pixabay

US multinationals are definitely going to feel the negative impact of the strong dollar on their corporate earnings, if not in the June quarter of 2022, in the coming quarters ahead. The corporate earnings season seems to have got off to an unusually slow start this time in India and across the world, and not all major companies have reported by the time this article is published on my blog. From the few that have, it appears that US banks have reported a healthy set of earnings, helped by trading income in both fixed income assets and equities. Wells Fargo, which is a huge player in mortgage loans suffered from the weakening of the property market that I mentioned earlier. Pepsico reported an earnings beat though they were impacted by the pared down operations in Russia, and a slightly weaker performance in their own home market especially in beverages. IBM reported a higher revenue and profit helped by their z-mainframe sales as well as consulting and software, while Netflix reported an even larger loss of subscribers, though not as many as they had estimated, and plan to launch a lower-priced ad-based segment early next year. There are a slew of tech earnings expected this week, as well as the US Q2 GDP preliminary read as this blog post goes live.

In India, the few tech companies’ earnings that have been reported are satisfactory, though they are all experiencing cross-currency headwinds, especially coming from Europe. The few banks’ earnings so far are reasonably good too, but with lower provisioning for bad loans, which have in turn been showing improvement. This ought to come as a relief to banks, customers and investors, since the Indian public sector banks’ bad loan problem is a grave one, going back at least a decade.

Oil and gas companies across the world are expected to report record revenue and profits, given the global prices of these commodities, with many countries planning to impose a windfall tax on the sector. Meanwhile, consumer staples and consumer packaged goods industries are likely to feel the heat of slowing demand, especially in the price-sensitive consumer segments. In India, Hindustan Unilever reported a good set of earnings in the June quarter of 2022, though the management commentary was that there is pressure from commodity prices and margin pressure as a result, even though the company reported a 19% increase in revenue mostly thanks to price increases. ITC too reported a reasonably good set of earnings. Relatively speaking, though, consumer staples are usually more resilient in downturns should there be one, owing to inflation weakening consumer demand.

The rate hike stranglehold will also be felt in capital markets as money returns to the US and other safe havens. Since the start of 2022, most countries’ equity markets are down, with portfolio investors pulling out vast sums. India alone has seen US $28.8 billion and US $112.7 million (approx.) leave the country’s equity and debt markets respectively and most of it has returned to the US. This affects poorer developing countries such as India, as we depend on foreign investment and with a high current account deficit, our balance of payments situation worsens. Thankfully, we have built reasonably good reserves of foreign exchange, but with the RBI trying to prevent the Indian rupee from falling further, this too will be under pressure.

A weaker currency also makes imports more expensive, and for countries such as India that rely on huge oil imports as well as capital equipment, it will send our import bills much higher. This will further dampen investment demand in the country, which had grown healthily after the pandemic lockdowns. A weaker rupee also puts pressure on foreign debt repayments. While high inflation helps reduce the debt burden by inflating most of it away, a weaker currency adversely affects the capacity to repay foreign debt. In India, our external debt according to RBI as of March 2022 was US $620.7 billion, of which US $ 303.5 billion is by companies, which works out to 48.8% of total foreign debt. Around US $255 billion comes due in the next few months, and even if high inflation helps reduce the burden, the weakening rupee will put pressure.

Speaking of debt, total global debt as I had written in an earlier post, is already at unprecedented levels. The latest figures show that global debt increased by another US $3.3 trillion in the first quarter of 2022, taking the total global debt to US $ 305 trillion. This is the third challenge facing companies and countries going forward. In trying to keep economies afloat during the Covid pandemic, governments across the world had run up huge amounts of debt. This is in addition to the debt incurred during the recovery from the 2008 financial crisis, much of which might be due for repayment later this year or the next couple of years. With weak currencies across the board, repaying these will be more challenging than ever before. What’s more, let’s not forget 2023 is going to be a year of slower economic growth even without taking into consideration the impact of rate hikes and the Ukraine crisis, thanks to a relatively high base effect. With 2021 and 2022 being years of recovery and growth from the pandemic, a negative base effect will come into play next year.

Businesses and governments need to make the most of 2022, therefore, or what is left of it. Because this is as good as it is going to get for a long while. Economists and politicians have been talking up the risk of recession in media, but I think what we ought to expect is a slowdown in growth until inflation is tamed. With the festive season beginning in India next month, and a good monsoon this year – albeit excessive in many parts of the country – we should hopefully see a spurt in consumer demand. While RBI needs to combat inflation soon, the Indian government has high unemployment to deal with.

And while the whole world needs to work together, keep trade channels open as much as possible without resorting to protectionism – even in supply chains – job creation is the responsibility of each country alone. In the case of India, solving this structural problem has been the biggest challenge of all.          

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