The pace of global GDP growth may be starting to normalise, but economic and policy cross-currents are still complicating the post-Covid recovery. Among the top concerns: Inflation expectations related to supply-chain disruptions; a new variant of the virus and spill-over effects from China’s growth slowdown.
This is an abridged version of our monthly Asset Allocation Outlook.
We see the inflation spike as temporary and believe rising vaccination rates should allow economies to continue to reopen, assuming the Omicron variant does not turn out to be resistant to existing vaccines.
The growth deceleration in China will likely remain manageable as Beijing gradually shifts towards (more) policy easing. Major developed countries’ fiscal stimulus should boost global growth.
The normalisation of central bank policy will likely also proceed gradually.
We believe that overall, this backdrop continues to favour risk assets (equities) over safe-haven instruments (bonds) as long as real yields remain low.
Fed tapering – And then what?
The US Federal Reserve is on course to wind down its monthly bond buying to zero by June 2022. That means its policies remain broadly supportive of the economy and therefore equity positive in the short term.
Next, it faces a challenge: How to balance maximising employment, while keeping inflation at 2% over the long term, but allowing it to moderately exceed 2% in the short term. The recent surge in consumer price inflation to its highest since the 1990s (at 6.2% YoY in October) is making this a precarious balancing act.
The Omicron variant is complicating things for the Fed. Supply-chain snarls and the shift in demand from goods to services could last longer, adding to inflationary pressure. However, it could also delay the re-opening of the economy, leading to weaker growth and employment, impacting 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 speed up the tapering process, clearing the ground for an early rate increase.
ECB doves, BoE hawks
So far, the stance of the ECB is dovish. President Christine Lagarde has appeared certain that the inflation spike is transitory and has rebuffed strongly the expectation of ECB rate increases in 2022.
This contrasts sharply with the Bank of England’s views. Governor Andrew Bailey currently sees rising inflation as the dominant risk. The only reason for the BoE to hold off on a rate rise is that it is assessing the impact of the end of the furlough scheme.
If the current price pressures do turn out to be transitory, and inflation falls back further and faster than the BoE expects, interest rates may not need to rise by much after all.
How will emerging market central banks react?
Some EM central banks have already started to tighten policy, driven by inflation fears rather than the risk of capital outflows. Latin American and eastern European central banks are likely to be more hawkish than their Asian counterparts because Asian economic fundamentals are better.
Moreover, the cyclical backdrop in Asia is soft, owing largely to low vaccination rates and China’s growth slowdown. That leaves Asian central banks in no hurry to follow any tightening in developed countries.
Assuming inflation does not affect real yields significantly, even moderate US fed funds rate rises would leave Asia with a comfortable real rate buffer. That should help reduce pressure on Asian central banks to follow suit. Any indiscriminate selling would present investors with a significant yield pick-up in Asia.
How big is the China risk?
Investors are worrying about a property market crash triggering a systemic crisis and sending seismic shocks across the global system. We believe the probability of this happening is low.
A shock to Chinese growth could dampen global growth and inflation pressures. Asia is especially 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 US might not be able to offset the drag on Asia.
Exhibit 1: Real rate* differentials between Asia (ex. Japan) and the US are significant (percentage points)
Data as of 21 November 2021, sources: CEIC, HSBC, BNP Paribas Asset Management
* deflated by core consumer prices (CPI)
Markets – Gearing up for normalisation
In the coming months, financial markets can expect to see central bank policy normalisation. However, if the fundamentals are supportive, this normalisation may not necessarily hurt the markets. As long as inflation is transitory and real yields are low, the macroeconomic backdrop still favours equities over bonds.
Meanwhile, emerging market equities (including China) are becoming attractive. After underperforming the MSCI World index for most of this year, the 12-month forward P/E ratio of EM equities relative to global equities has fallen to a 10-year low. China risk appears to have stabilised.
In fixed income, markets are pricing in more rate rises at the front end than at the back end. This process has already led to inversion of the Treasury yield curve. But for now, the markets still have confidence in the main central banks, as evidenced by moderate long-term inflation expectations.
Asset allocation – Short in 10-yr USTs
We are still long equities. Reflecting the expectation of an emerging market equity recovery, we have added a long position in global EM equities and reduced our long US equities position.
In our developed market equity positions, we have reduced European small caps in favour of North American small-cap and European large-cap stocks. European large caps should have more ‘legs’ thanks to the delayed recovery in the region. We have kept our long Japanese equities position.
Although we are not bond bears yet, the prospect of higher yields makes US Treasuries look precarious. Hence, we have added to our tactical short position in 10-year Treasuries. We believe net long positions in the US dollar are crowded. We foresee bouts of appreciation, but are avoiding being short carry.