We view the spike in inflation as temporary and believe rising vaccination rates should allow economies to continue to reopen, assuming the Omicron variant does not prove resistant to existing vaccines.
China’s growth deceleration is likely to remain manageable as Beijing gradually moves towards (more) policy easing. Fiscal stimulus from major developed countries is expected to boost global growth.
The normalization of central bank policy will also likely continue gradually.
We believe that overall, this environment continues to favor risky assets (equities) at the expense of safe havens (bonds) as long as real yields remain low.
Fed tapering – And then what?
The US Federal Reserve is on track to reduce its monthly bond purchases to zero by June 2022. This means that its policies remain broadly supportive of the economy and therefore positive for stocks in the short term.
Next, it faces a challenge: how to balance maximizing employment, while keeping inflation at 2% in the long term, but allowing it to moderately exceed 2% in the short term. The recent surge in consumer price inflation to its highest level since the 1990s (at 6.2% year-on-year in October) makes this a delicate balancing act.
The Omicron variant complicates matters for the Fed. Supply chain disruptions and the shift in demand from goods to services could last longer, adding to inflationary pressure. However, it could also delay the reopening of the economy, leading to weaker growth and employment, which would impact the outlook for Fed policy.
Other major central banks, notably in the UK and Canada, are becoming more hawkish. This adds pressure on the Fed to accelerate the process of tapering, paving the way for a rapid rate hike.
ECB doves, BoE hawks
So far, the ECB’s stance has been dovish. President Christine Lagarde appeared certain that the spike in inflation is transitory and strongly pushed back the expectation of an ECB rate hike in 2022.
This contrasts sharply with the views of the Bank of England. Governor Andrew Bailey currently sees rising inflation as the dominant risk. The only reason the BoE is delaying a rate hike is to assess the impact of ending the furlough scheme.
If the current price pressures prove to be transitory and inflation recedes further and faster than the BoE expects, interest rates may not need to rise much after all.
How will emerging market central banks react?
Some emerging market central banks have already started to tighten policy, driven by inflation fears rather than the risk of capital outflows. Central banks in Latin America and Eastern Europe are likely to be more hawkish than their Asian counterparts as Asian economic fundamentals are better.
Moreover, the cyclical context in Asia is gloomy, mainly due to low vaccination rates and slowing Chinese growth. Asian central banks are therefore in no rush to follow any tightening in developed countries.
Assuming that inflation does not affect real yields significantly, even moderate increases in US fed funds rates would leave Asia with a comfortable cushion of real rates. This should help reduce pressure on Asian central banks to follow suit. Any blind selling would offer investors a significant boost in returns in Asia.
How big is the Chinese risk?
Investors worry that a housing market crash would trigger a systemic crisis and send seismic shocks throughout the global system. We think the likelihood of this happening is low.
A shock to Chinese growth could dampen global growth and inflationary pressures. Asia is particularly worried because it is more sensitive to changes in GDP growth in China. If growth in China were to slow sharply, even strong growth in Europe and the United States might not be able to compensate for the slowdown in Asia.
Chart 1: Real interest rate differentials* between Asia (excluding Japan) and the United States are significant (percentage points)
Data as of November 21, 2021, sources: CEIC, HSBC, BNP Paribas Asset Management
* deflated by underlying consumer prices (CPI)
Markets – Preparing for standardization
In the coming months, financial markets can expect a normalization of central bank policy. However, if the fundamentals are favorable, this normalization will not necessarily hurt the markets. As long as inflation is transitory and real yields are low, the macro backdrop will always favor equities over bonds.
Meanwhile, emerging market stocks (including China) are becoming attractive. After underperforming the MSCI World Index for most of the year, the 12-month forward price-to-earnings ratio of emerging market equities to global equities fell to its lowest level in 10 years. The Chinese risk seems to have stabilized.
In fixed-income securities, the markets are pricing in more rate hikes at the entry than at the downstream. This process has already led to the inversion of the Treasury yield curve. But for now, markets still have confidence in major central banks, as evidenced by subdued long-term inflation expectations.
Asset allocation – Short in UST 10 years
We are still long on stocks. Reflecting the expectation of a rally in emerging market equities, we added a long position in global emerging equities and reduced our long position in US equities.
In our developed market equity positions, we reduced European small caps in favor of North American small caps and European large caps. European large caps should have more “legs” thanks to the late recovery in the region. We kept our long position in Japanese equities.
Although we are not yet bearish on bonds, the prospect of higher yields makes US Treasuries precarious. Consequently, we added to our tactical short position in 10-year Treasury bills. We believe that net long positions in the US dollar are crowded. We anticipate episodes of appreciation, but avoid being short carry.
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.
The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.
Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.