fixed income
How will rising stagflation risks affect Switzerland?
Need to know
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Stagflation risk gathers
Persistent inflation combined with fears of recession have increased concerns about a stagflationary global outlook. Currently, the global economy is faced with Covid-driven supply issues, a tragic war in Ukraine, a hit to wheat production, higher food prices, soaring metals and commodities prices, and an energy price shock. Could this combination of factors reduce growth and prompt stagflation? The risk of this scenario is clearly increasing.
As global inflationary pressures continue to build from already elevated levels, we see price rises stemming from two shocks:
- Previous, Covid-driven shocks: these were predominantly to supply chains, but also included demand increases resulting from massive government stimulus.
- Current shocks from the Russia-Ukraine war: the war has exacerbated previous inflationary pressures, leading to higher food, energy and commodity prices, while trade sanctions compound on-going supply chain pressures.
The Swiss economy proved relatively immune to the first, Covid-driven shock but is now beginning to succumb to the global pattern of rising prices. For instance, headline Swiss CPI inflation is on the up, and is elevated for the SNB’s standards, meaning prices are above the bank’s definition of price stability.
The flattening of the US Treasury yield curve is signalling market worries about future growth, though major central banks have been less vocal on this aspect. The ECB and Fed have openly said they are more concerned about high inflation currently, which implicitly makes them less focused on growth.
Sticking to tightening plans
We believe central banks will stick to their timing for tightening monetary policy. The Fed delivered its first 25bps hike this monthly and has laid out plans for further rises this year that could be in larger increments. Meanwhile, the ECB has brought forward the reduction of its purchasing programme schedule and opened the door to a rate rise at the end of 2022.
Some similarities exist with historical supply-side shocks that occurred in the 1970s and 1980s1. Typically, central banks ‘look through’ supply shocks because these cannot be resolved by monetary policy. Today, supply shocks are only partly responsible for higher inflation, and central banks appear set to deliver a series of hikes to address rising prices. That said, even the forecast aggressive rate increases will still likely result (in total) in a lower terminal rate than in historical episodes. Although the global economy is currently running hot, we expect the central bank response to be more tempered due to high levels of leverage in the system and elevated debt levels limiting room for extremely aggressive policy tightening.
Central banks will be forced to take into account the impact of slower growth later this year, in our opinion. Indeed, the latest ECB projections allowed for an inflation shock from the current context, but its growth projections were less influenced. We believe the ECB is too optimistic about growth because the outlook is subject to high levels of uncertainty from the geopolitical situation and the global economic slowdown.
Overall, we expect global central banks to look through concerns about stalled growth and continue with their planned hikes. This may change by the end of the year.
Swiss franc matters
The deterioration in sentiment and risk aversion from geopolitical risk have prompted safe-haven buying of the Swiss franc, firming the currency considerably on foreign exchange markets.
There is potential for a serious escalation in the war to spur further franc buying as a safe-haven currency, though we see this as unlikely. Instead, our central scenario is that the Russia/Ukraine conflict proves lasting but remains local without further major economic disruptions on a global scale. High volatility could persist as diplomatic efforts prove be slow.
The link between the strong franc and inflation is significant. Much of Swiss inflation is imported, meaning the currency appreciation should temper the impact of global price rises in Switzerland in the coming months. Preventing the franc from becoming over-valued is a key plank of SNB policy. Yet the ability of the currency to dampen imported inflation gives the SNB wiggle room because it reduces the urgency for the bank to verbally intervene (or act) on the currency.
Parity break a one-off?
Importantly, the franc broke parity against the euro in early March. While this may tame inflationary pressures, it could equally impact Swiss growth prospects because a volatile currency could make companies more reticent about capex and R&D investments, in turn hitting growth. Generally, the market has become more optimistic safe-haven flow will ebb as the conflict persists but in lower gear, leading to expectations that the parity break was a one-off. That said, the overall trend is for further franc strength: going forward, parity could well be broken again.
Given prominent currency moves, we also note the important difference between the nominal and real exchange rates, as shown in figure 1. The nominal exchange rate has logically moved higher to reflect the divergence in inflation. In contrast, the real exchange rate (which is agnostic to inflation differentials) has been notably more stable.
Figure 1. Nominal vs real broad CHF effective exchange rate
Source: JP Morgan. As of March 2022. The CHF effective exchange rate is against a basket of currencies, of which the Eurozone is the largest contributor.
Limited Swiss links with Russia and Ukraine
The Swiss economy’s trade links to Russia and Ukraine could be impacted by the current crisis, but we expect the potential effect to be long-term, if any, because the concerned economies are not highly linked. Total trade with Russia and Ukraine represents less than 1% of Swiss GDP.
As such, we do not see trade sanctions specifically impacting the Swiss economy, although the previously stated inflationary pressures from commodities and energy will endure.
SNB ups CPI outlook
Monetary policy is finally moving. Both the Fed and the ECB are fighting rising inflation, accelerating normalisation and, in turn, remaining vague (as opposed to cautious) on growth despite the conflict in Ukraine. At its March meeting, the SNB decided not to follow suit yet, however, instead maintaining language consistent with its past communication.
For instance, the SNB retained its expansionary monetary policy, warned that the franc remains highly valued and said it will continue to monitor developments in mortgage markets.
Nonetheless, some things also changed. First, the SNB is tolerating a stronger nominal exchange rate and appears to be intervening less in currency markets to weaken the franc. Second, the SNB currently accepts inflation running above its own definition of price stability of 2%.
Indeed, the SNB substantially increased its inflation projections and it now sees inflation peaking at just over 2% this year before receding into 2023 and 2024. The current forecast is some three times higher than the bank’s June 2020 prediction of CPI at 0.2% for 2022, as shown in figure 2.
Figure 2. Swiss CPI: actual and SNB forecast
Source: Federal Statistics Office of Switzerland, SNB, Bloomberg and LOIM. For illustrative purposes only. CPI figures as of February 2022. SNB projections end at December 2024.
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Overall, this suggests to us that the SNB will probably wait for the ECB to take the first interest-rate step but could then follow suit relatively quickly. This could play out by early 2023, in our opinion. |
Sources
[1] We refer to inflationary episodes in 1973-1947 and 1978-1980
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