The post-global financial crisis era was marked by low growth and low inflation, due to errors of policymakers. The dominance of central banks in that environment proved very supportive for financial assets. In that falling yield and low-volatility world, economic outcomes were poor as central bank liquidity flowed directly into financial assets.
Now we are in a different era. The macroeconomic environment is changing, inflation is higher, labour shortages are an issue, and this is not going away soon. We are in a world of tight supply, the commodities markets — metals, agriculture and energy — are all expensive because of this.
Wider and deeper
One of the reasons central bankers have gotten worried is they are seeing service prices rise, and in the consumer price index (CPI), the percentage of goods that is creeping above the 2% inflation target is growing. It’s spreading to a larger number of goods and services.
These inflation figures are making the central banks tighten, yields are rising, and policymakers are going to pull back liquidity. Central bankers want to reduce liquidity not just hike rates because politically they need to be negative for some aspects of the markets.
The US Federal Reserve (Fed) in January said it would begin reducing its $9trln balance sheet soon, a process called quantitative tightening (QT). The Fed also said it would continue to reduce the monthly pace of its net asset purchases by $20bln for Treasury securities and by $10bln for mortgage securities, bringing the purchases to an end in March.
The Fed wants a steep yield curve and a weaker dollar and recognises that bad things happened in the past when they have over-tightened rates and caused the dollar to rocket higher. My view is that to avoid that happening again, the Fed is going to use quantitative tightening in a bigger way this time. It also makes sense politically to use QT at the same time as raising rates.
In a rising yield and lower liquidity world you must be flexible. Previously investors could buy anything with yield, almost any company could issue debt and survive. Now that is not going to work. You need to be flexible enough to take short positions and you also need to avoid lower quality assets because they most likely are going to underperform. You have seen that in the technology sector, where higher quality names have held up better.
Central banks balance sheets are still growing…
…but the growth has already slowed significantly
Source: Bloomberg, as at 31.02.2022.
Long and short
That is a sensible repricing of risk, which markets are supposed to do. But markets hadn’t done that in the era of excess liquidity. You have to be able to both go long and take short positions. That is important in the reverse liquidity world.
The central banks everywhere have become very good at crisis fighting because they have had a lopsided growth where markets break very quickly. The Fed knows that liquidity and accessing dollars overseas can be an issue, especially when they raise interest rates and pull back fiscal support, so they have created standing repurchase (repo) facilities to try and prevent the rate hiking cycle getting short-circuited, or having to stop too early, as they have had to do in the past. The markets are still not very confident about that. At the time of writing, they are pricing in six rate hikes this year and two next year, and then a rate cut. We don’t agree with that scenario.
Synchronised global growth
We do think the global growth dynamic – synchronised global growth – where central banks around the world are tightening, with the availability of liquidity programs such as the standing repo, and fiscal support from governments including the recovery fund in Europe and support for the green economy, should ensure that this hiking cycle will not roll over as has happened in the past. This should allow central banks to tighten rates and withdraw liquidity successfully.
In this scenario of synchronised global growth, it seems sensible to us to sell dollars, buy emerging markets assets and to sell developed market sovereign bonds. Investment grade credit may struggle to make returns.
The main risks to this view are that US inflation remains elevated, which would cause more near term hikes. Geopolitics, including Ukraine and Russia, are a risk and so too is weak growth in China.
It is the era of reflation of the global economy and tightening by central banks. With synchronised global growth, we think it makes sense to look to non-dollar higher yielding global government bonds, especially emerging markets. There have already been substantial rate hikes in many emerging markets that were unable to ignore rising global inflation in 2021 as much as the US. Developed market sovereign bonds globally will most likely remain under pressure as rates rise and inflation fighting begins. Investment grade and high yield credit may struggle to make returns as liquidity is withdrawn and the low inflation era ends.
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The value of active minds: independent thinking
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