Transcript podcast 

[Hiba Mouallem]: Hello, welcome to this weekly podcast by BNP Paribas Wealth Management. My name is Hiba Mouallem. I'm an investment strategist. Today, I'm joined by Guy Ertz, Deputy Global Chief Investment Officer at BNP Paribas Wealth Management, to discuss a primary risk associated with the Iran War, namely inflation, and its impact on the global economy. Hello, Guy.

[Guy Ertz]: Hello, hi.

[Hiba Mouallem]: Guy, this conflict between Israel and Iran has been dragging on since the end of February. Given the huge uncertainty over how long the conflict will last, there is widespread concern over the repercussions on the global economy, including the risk of stagflation. Would you please start by defining stagflation and explain why it is a risk today?

[Guy Ertz]: Sure. Well, stagflation has basically two components. It's not about only high inflation but also low growth. So basically, the combination of low growth and high inflation is typically what we call stagflation.

Now, what is the risk today to have such an outlook? Well, we have to keep in mind that in the last few decades, the central banks have been adopting a so-called inflation targeting policy, where they have an explicit inflation target. And of course, if this target is at risk, they can adjust the interest rate to really make sure that they keep on track for that objective of inflation. In Europe, typically, the ECB has a two percent target for inflation, and this is important because the ECB is very much focused on keeping its credibility in that sense. And that is actually why we think for Europe in particular, but also for countries that have a relatively strict inflation targeting model, such as the UK, for example, we have a relatively low risk of stagflation and particular high inflation. Why? Well, the countries have been showing that in the 2022 period, where we had two consecutive shocks with the post-COVID supply chain constraints and then the conflict in Ukraine and the energy crisis, the central banks have been actually rapid in terms of adjusting interest rates to the upside to cool the demand and bring inflation lower.

And we think that for countries that have this explicit inflation targeting, also in this kind of environment, we think that they will act if necessary. That is really why we think for most of those countries, really the stagflation risk, and in particular the inflation component, is actually a low probability outcome.

For the U.S, it's maybe a little bit less clear-cut. I mean, the risk of stagflation is probably somewhat higher. Why? Well, first of all, the Fed has a so-called dual mandate, so they're not only looking at inflation, but also at maximizing employment. And also, they have been stating many times that they can be focusing, depending on the environment, more on one or the other targets. So that makes the situation somewhat different for the U.S. And it is possible that the U.S. can be tolerating somewhat higher inflation, at least temporarily, compared to countries like the eurozone or the ECB, in terms of central bank.

So for the U.S., the risk could be somewhat higher purely from a central bank policy point of view. Also, there's been some debate recently about the independence of the U.S. central bank. It's probably somewhat off the table right now, but it's still an issue potentially for the coming years. So that is why we think for the U.S. the stagflation risk is probably somewhat higher than for countries where central banks have explicit inflation targeting, as for the ECB.

Maybe also to just remember that, of course, from a central bank point of view, as I mentioned, the U.S. is probably somewhat more at risk from a stagflation scenario. But the starting point and the environment for the U.S. is somewhat more favourable compared to the eurozone, in particular when it comes to the energy dependence. The U.S., of course, is much less vulnerable compared to the eurozone. The eurozone has done some good adjustments in terms of inflation before the Iran strikes. While in the U.S., inflation remains somewhat sticky, but clearly, all in all, the stagflation risk is globally low, and it is even lower for those countries that have explicit inflation targeting.

[Hiba Mouallem]: Considering then that stagflation remains a low probability, what is your base-case scenario for growth and inflation?

[Guy Ertz]: The environment right now is really an environment where all is about the escalation outlook, and that is also our base-case scenario. So we are looking for gradual de-escalation in the conflict. We do, however, say that, and we do, however, include a scenario where oil prices will not fall all the way back to previous levels or levels seen before the Iran strike, so we would see all prices coming down gradually, but not going below eighty dollars. So keeping that in mind and the fact that also it will take quite some time to have a full normalization of some supply chains, in particular in the in the energy part, it is very likely that we will have to revise somewhat lower our growth outlook.

But we’re still not looking for a for recession risk. We're looking for a gradual slowing of growth. On the inflation side, we expect inflation to be rising for headline inflation, and inflation that includes the energy component. But we do not see that as a risk or as an effect that will last over time because we are not expecting so called “second round effects”, meaning we are not expecting companies to be fully passing on their cost increases related to energy to their final prices. So we should see a temporary rise in headline inflation, maybe also core inflation for a short period of time. But if we look at the one to two-year horizon, we should see inflation normalizing. So that is really the base case scenario when it comes to growth and inflation.

[Hiba Mouallem]: Perfect. Thank you. And on another note, global public debt and the worldwide deficit are at very high levels currently. How can governments stem the rise in debt without jeopardizing growth?

[Guy Ertz]: Well, I mean, first of all, we need to just look a little bit at what happened in the last few years in terms of debt and deficit. We have seen actually the debt levels rise due to COVID because countries have been forced to include higher expenditures to support the population and the companies. We have seen, however, some countries being able to reduce again somewhat their debt afterwards, in particular some southern European countries like Portugal, for example, or Greece.

What is important to monitor now is the deficit dynamics. The deficit is basically the difference between income for the government and expenditures, and it adds to the debt if it is a deficit. So meaning, if there is a deficit, that will be the part that adds to the existing debt. So that's why deficit dynamics are so important to monitor. There are some countries that are facing some higher deficits. We need to monitor that more closely. It's also interesting to see that we have some kind of golden rule where we look at, which is that. It can be shown that countries that have a growth rate that is higher than their borrowing cost, that those countries, if they don't generate new deficits, are clearly on a stable path. So the difference between the nominal GDP growth and the borrowing cost related to the debt is a very key criterion.

Most of the countries are actually still in positive territory when you take that difference, in particular when you consider the borrowing cost really, looking at the average weighted coupon of the debt, so that is more positive news. But yeah, I mean the deficit part is the worrying part, and yes, countries of course can work both on the expenditure side and on the income side. The income side obviously is the tax side, and the expenditure side is related to anything that really the government has to take as an expenditure, be it be the salaries, for example, or others. We have seen actually a country like Portugal doing really a tremendous job in terms of surplus generation, meaning the opposite of a deficit. So it is really possible, and an example like Portugal is very interesting here.

[Hiba Mouallem]: Okay, thank you so much, G for all your answers, and thank you to our audience out there listening to this podcast. Please like, share, and subscribe to our series of podcasts. Until next time, goodbye.

[Guy Ertz]: Thank you. Byebye.