It’s been a year of hopes and disappointments. The global economy, which was in the doldrums most of last year due to coronavirus, saw a ray of hope in the beginning of 2021 as vaccines promised to set things right. The buzz was all about reflation in the early part of the year, underpinned by easy monetary policy and copious fiscal spending.
As the year draws to a close, the excitement has died down. After briefly encountering the ominous term `stagflation’, inflation is threatening to play spoilsport now. Surging prices are worrying policymakers and financial markets alike. In most parts of the world, the rise in prices is attributed to supply crunch inflicted by skewed logistics during the pandemic. In the US, a surge in consumer demand added to supply chain issues, pushing inflation to the highest level in more than three decades. Higher oil and gas prices aren’t helpful either.
In this context, it’s natural to wonder what’s in store next year? All stakeholders are trying to second guess the course of action of major central banks to the situation. But they are caught in an uneasy conundrum: while economic growth optimism seems to have taken hold in the US, the rest of the world is still reeling in the aftermath of the pandemic.
Among central banks, the US Federal Reserve (Fed) has already started tapering asset purchases, the Bank of England had a false start with rate increases and the European Central Bank doesn’t seem to be in a hurry to do anything as its economy is far more aligned with China.
The key to solving this puzzle will be China, as the efforts of policy makers to deleverage the economy for greater financial stability has coincided with the pandemic. The weakness in the world’s second largest economy is driven by tighter fiscal spending, reduced capital expenditure and halting of credit splurge. High savings rate, which is typical of China, and lacklustre consumer demand are also not favourable factors. There are tell-tale signs of trouble in the property sector as exemplified by Evergrande.
Add to the mix a strong renminbi and high real rates, the prospect of a quick revival looks out of question. While exports are doing well, shipments aren’t good enough due to the worldwide sluggishness. China isn’t making any efforts at all to reflate and that doesn’t augur well for global growth.
This scenario is captured by the aggressive bear flattening of the yield curve (yields on bonds due in the short term are rising faster than the long-term bonds). Bonds with lower maturity are rising briskly following the hawkish turn of central banks to tame inflation.
Policy makers can’t be seen to be doing nothing when inflation quickens. At the same time, they can’t afford to commit a policy mistake by tightening too early.
Currently, we are long dollar (expect dollar to rise) and short US rates (bet prices may fall) versus the rest of the world in our strategy. A rising dollar is cushioning high imported prices of goods, especially from China. I think the Fed would prefer a strong dollar and aim to tighten conditions with which finance can be accessed by businesses and households by inducing higher volatility.
Such a policy will prevent a substantial bond market selloff. However, a strong dollar may strain emerging markets as they’ll be forced to tighten their monetary policies to keep their currencies from sliding, which may again act as headwind for growth. The ingredients for a bond selloff are weaker dollar and/or low real rates and broad-based growth. We are not witnessing this now.
As we enter the new year, the Fed will continue to talk tough about its policy intentions, which may create opportunities to buy Treasuries. Although market concern can grow about rate hikes, in the end we don’t expect their rate hikes to match what’s been priced in as growth outside of the US will be a concern. That’s why the terminal rate, the proxy for what the peak Fed Funds rate will be in the current cycle, has remained low. Volatility is likely to short circuit the front-end move eventually.
We will look to reset our views sometime in 2021 if the environment unfolds as we expect and we expect volatility, which will help to steepen the yield curves and make risk assets cheaper. We also expect emerging market assets to be cheap next year.
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