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Winter Wonderland or one of Discontent?

By John Finn, Managing Director at Treasury Solutions Ltd.

As the evenings shorten and close in, there is a semblance of normality returning to business for most after a surreal 18 months. Government supports have protected many businesses, but the pandemic period has been uneven in its impact. Many firms have suffered minimal impact, some have even thrived but others such as hospitality and, particularly, the arts and live entertainment have had a very difficult time.

So, as we enter the last quarter of 2021,  it is worthwhile looking at a few key risks and possible trends for the remainder of the year and beyond.

Currencies

The key currency from an Irish perspective is Sterling (GBP). After a Brexit-induced rocky few years, the currency has settled in 2021 which has been a welcome relief to Irish exporters to the UK. Graph 1 below shows the average monthly rate for 2021. The key takeaway from this graph is that exporters are getting an extra 4% net margin on UK sales in September compared to January 2021 and an extra 6% versus the same month last year. Money for jam you might say! However, the September figure also represents a “bottoming out” of the GBP strengthening trend for 2021.

Graph 1. EUR/GBP 2021 Average Monthly Rates


The action point for the remainder of this year is not to assume that GBP will either strengthen further or even hold all of the 2021 gains.

The trend in EUR/USD  has been somewhat similar in 2021 but the general trend since 2017 has been for weakening USD (2018 average was EUR/USD1.1198, 2021 year to date average is EUR/USD1.1964.)

Thus, exporters to the US (and to USD-linked currencies such as the Gulf States) experienced a positive impact on the profitability of USD sales over the period 2018 to May 2020 of 10%  but that was eliminated over the following 12 months before stabilising again.

The driver of future direction in both GBP and USD versus EUR will primarily be sustainability of GDP growth, inflation and geo-political considerations. As all three are quite unpredictable at this point in time, it points to further currency volatility unfortunately. 

Interest Rates

There is little point in showing a graph of short-term EUR rates such as 3-month euribor as it has  moved very little over the past number of years and has been negative since May 2015!

The most noteworthy trend on the interest rate front in recent times is the upward move in US government 10-year bond rates which have risen from 1.18% at the start of August to a current level of 1.52%. This increase is largely attributed to ongoing concerns around future inflationary trends. We examine this further below as it is a key risk on a number of fronts.

Inflation

Inflation has been benign. In Ireland, the rate has varied between 0% and 5% broadly speaking since the late 1980s and since the last financial crisis in 2008 (when the rate fell to -5% in 2009/10), it has hovered around 0% to 1%. Most recent reading was +1.4% in July 2021. The last time we experienced inflation of 5% was the noughties when interest rates were low, house prices were high and economic growth was strong……sound familiar? 

Internationally, the focus has been on the US where inflation jumped from +1.4% in January to 5.4% in June and has remained in or around that level over the Summer. The debate is whether this trend is temporary or likely to be sustained. To date a lot of “officials” are taking the former line but I’m highly sceptical. Mathematically, if prices hold at current levels over 12 months, the inflation rate falls to 0%. But if it costs €250 more to fill my oil tank this year compared to last year and holds at that level next year, I’m still €250 worse off next year unless my wages increase! And, of course, if I seek higher wages on a sustained basis in response to these price hikes, we enter into a wages/price spiral which is what dogged so many countries in the 1970s, 1980s and into the 1990s. 

Inflation is a potentially huge issue as it impacts all companies and individuals, but not equally! High house prices/rents and childcare have a material effect on the finances of workers with young families compared to people in their 50s who most likely bought their houses decades ago and have an empty nest. The large increases in energy and international freight prices will impact more on manufacturers and international traders compared to those involved in the service industry.

In a broader sense, higher inflation will impact on government and corporate borrowing (driving up interest rates). Higher debt service costs for governments require higher taxes and/or lower expenditure to balance the books. Pensions are also affected through bond and equity price trends.

I would rate this as the number concern coming into 2022 and it requires active consideration and management in the preparation of 2022 budgets. 

Energy and the Environment

Some of the inflationary pressures have arisen due to the jump in oil, gas and electricity prices. Graph 2 shows the price of Brent Crude over the past 2 years. The trend is self-evident. And Bank of America recently called USD100 per barrel by Summer 2022 (or sooner if there is a harsh winter!).

Graph 1. EUR/GBP 2021 Average Monthly Rates

The cost of pollution can also be monitored through the price of carbon credits. The price of EU Carbon credits has increased from €25/tonne in 2020 to over €50 by Summer 2021 and €61/tonne currently. Increasingly, companies that produce CO2 as part of their operations must purchase carbon credit offsets thereby putting a measurable cost of the activity. The finance world is only starting to grapple with how to measure sustainability performance, but this will continue to develop. And will be costly to those that don’t adapt in order to reduce their carbon footprint. It is forecast by some in the market that companies will have to really engage in this space if carbon holds above €75/tonne on a sustained basis. Worth monitoring this from now on I would suggest.

Geo-political Risks

I referenced this in the January “crystal ball gazing” article written for you. I reiterate it here as the role of Government has increased since the financial crisis of 2008 and the pandemic more recently. Government borrowing has exploded in most countries and government (capital) spending remains a key part of the economic recovery story. But borrowings have to repaid implying sustained positive current accounts (excess of income over expenditure).

Allied to all of this is the changing shift of power to the East and the difference in population trends (falling and ageing in Europe, young and growing in Africa).
These can have profound changes in how business in done and we are already starting to see it in the breakdown of global supply chains which is likely to continue. “Just in time” has been replaced by “Just in case”. Europe remains heavily dependent on Russian gas. US security focus turns away from the Middle East to the Pacific Rim and so on. 

In an open economy such as ours, we will be more exposed to many of these changing trends so they must form part of any strategic planning process of any company.

Summary

The economic outlook is broadly positive at this point in time, but the above list shows that there remains a lot of potentially significant risks which can either be managed or may be catered for by altering corporate practices. What is likely is that the 20’s will require adaptability and flexibility in the manner in which we run our businesses and manage the inherent risks. And all of this against macro challenges such as climate change and geo-political tensions. It’s a lot to juggle, especially when planning for the long-term. But ignoring such issues is not an option either.   

About John Finn: 

John has 29 years’ experience in Corporate Treasury and Debt Financing gained in Ireland and the UK, working for publicly quoted and private companies prior to establishing this business.  His niche expertise in Treasury Risk Management and Debt Funding since qualification as a Chartered Accountant.  Since founding the business in 2001, he has advised on deals totaling over €10billion.  John’s focus is on adding value and working with Finance Directors and CEOs to reduce financial risk inherent in business and is a provider of strategic advice to Boards in their financial structuring and negotiations.  The goal of the Partner-level service is to provide corporate clients with the benefit of a full-time Treasurer on a project or ad hoc basis.

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