Higher inflation is putting pressure on central banks to raise interest rates earlier than expected. This could have a disastrous impact on global economic growth, which already faces a series of headwinds heading into 2022, say Ariel Bezalel, Head of Strategy, Fixed Income and Harry Richards, Fund Manager, Fixed Income.
Inflation coming in hot as global growth cools
Christmas may be more expensive this year as current inflation continues to run hot. Fortunately for consumers, we firmly believe that inflation is transitory, caused by supply chain shortages and increased demand following a year of partial global lockdowns, and will recede in 2022. Even so, central banks are under pressure to accelerate tightening. While the US Federal Reserve (Fed) and the European Central Bank have remained dovish so far, Australia’s central bank has panicked into tightening, and the Bank of England continues to dither. Inflation is also putting pressure on consumers, who are feeling the pinch of higher prices, and wages are declining in real terms.
Heading into next year, we believe the global economy is set to slow sharply, driven in large part by China and uncertainty around the new coronavirus variant. So far volatility in Chinese real estate has been confined to China but we expect its effects to ripple out across the rest of the world. 80% of Chinese household wealth is concentrated in domestic real estate. Chinese import demand is already suffering as consumption is diverted into building up lost savings, and there are also emerging signs of a slowdown in Eastern Europe, which is a key bell weather of Chinese demand because much of Western European industrial production is concentrated in that region.
Stimulus set to be reined in as ‘money taps’ turned off
One of the key drivers of the economic recovery from the effects of lockdowns caused by the pandemic has been incredible levels of monetary and fiscal stimulus. Across the G4 we are about to see monetary and fiscal tightening to the tune of $5 to $7 trillion, roughly equivalent to Japan’s GDP. The rate of central bank easing is already decelerating, and money supply growth is slowing. This is driving the dollar higher, which will weigh on inflation in months to come.
Tapering may not quite be what it seems
Whilst the impacts of interest rate hikes are well appreciated, when it comes to tapering (slowly phasing out bond purchasing programme by the Fed) many believe they prompt yields to rise. We believe this is a misconception. Historically, as seen through tapering in 2014 or quantitative tightening in 2018, when stimulus is withdrawn, Global PMIs (purchasing managers index) have fallen, and sovereign bond yields have followed suit. In our view, this dynamic is worth bearing in mind as the Federal Reserve embarks on its tapering program.
Central banks must tread carefully
Given these headwinds, central banks need to tread carefully. As growth peaks and slows into next year, there is a real risk that central banks tighten policy into a slowdown, and will be forced into a rapid change of course.
So, how are we addressing these issues in our portfolios? We believe that developed market government bond yields in places like Australia and the US are very attractive at these levels and have room to come back down in the medium term. They also act as a good ballast to risk in the portfolio. We continue to find interesting opportunities in high yield (bonds which pay a higher interest but have a higher risk of defaulting), relying on credit analysis focussed on identifying opportunities by studying companies’ balance sheets and market valuations. Within the high yield sector, we prefer shorter maturity bonds which are less sensitive to interest rate changes and therefore help to reduce risk. Given the uncertain global economic outlook, we are circumspect on emerging markets, but we do see an opportunity for Chinese government bonds, which we expect to rise in value as China is eventually forced to ease policy. The key for us at the moment is ensuring portfolios can continue to offer an interesting level of yield while being able to navigate a much more uncertain year ahead.
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