Omicron uncertainty; inflation certainty
The resurgence of the virus cycle, central banks’ reactions to high inflation figures, and Evergrande’s unavoidable default have led to some volatility in the market, but these issues have not caused any major disruption. In the battle between growth and inflation narratives, the mantra that bad news is good news for markets continues to prevail. At this point, it is definitely too early to make a judgement on the Omicron variant and its impacts. Investors should be aware that the virus cycle will be in focus once again. The new variant may affect the fragile parts of the supply chain, further adding to inflationary pressures. Importantly, there is a psychological element in the inflation situation currently offering a self-fulfilling narrative. This is definitely a risk to take note of moving into 2022.
Nonetheless, the level of concern is not in the red zone yet, but the Fed’s tone turned more hawkish, with Chair Powell speeding-up the tapering process. Despite the Fed’s shift to reducing accommodation, policy will remain easy in 2022, with the Fed Funds rate well below the “neutral” rate, a level where monetary policy neither stimulates nor restrains economic growth. In fact, the reaction of equities is an illustration of the market’s belief that the Fed will master inflation while not hurting economic growth, and that this episode will only be temporary. However, we think the situation will not be so straight-forward.
Amid tight labour markets (wage pressures) and strong consumer demand, we could potentially see demand-side pressures on inflation. So, the Fed is walking on thin ice: on the one hand, inflation is barely sustainable from a political standpoint; on the other, excessive tightening of financial conditions, causing market turbulence, would be equally unsustainable. The Fed will do something, but will likely remain behind the curve with tapering and rate hikes in 2022 and it will likely keep rates at very low levels.
The third item on the news front is China: the Evergrande and Kaisa groups have officially defaulted. So far, we see no signs of contagion. China’s government had also been active in recent weeks in supporting the real estate sector and taking a major role in the Evergrande’s restructuring. The policy stance looks much more constructive in 2022 vs 2021 and we believe that will be an important element. Against this backdrop, we see some key considerations for investors:
- Rising uncertainty and the risk of policy mistakes point towards a neutral stance for risk assets. Equities will continue to be favoured based on a TINA (there is no alternative) argument as long as real rates remain deeply depressed and inflation expectations are well anchored. The recent buy the dip move signals that market sentiment is still upbeat, despite high valuations and falling real earnings yields. Hence, once again, investors should selectively favour sectors and businesses that can better navigate an inflationary environment and should prever value given the wide valuation gap vs growth.
- In fixed income, after the Fed’s move, while 2Y Treasury yields fully priced in the FOMC’s projected pace of rate hikes, intermediate- and longer-term yields did not. We see risk of a bearish steepening of the yield curve. This reinforces our negative view on duration. In credit, the recent spread widening, especially in the quality part of the market (IG), may offer some room to add exposure, but very cautiously and in the short duration part. A scenario of decent growth, easy fiscal policies, behind-thecurve CBs, and continued global demand for yield remains supportive for credit, and in particular for the segments that can withstand inflationary pressure and don’t suffer from extreme leverage.
- In EM, investors should look for opportunities to play the asynchrony in policy responses. EM is a divided world between countries and CBs that are taking inflation seriously and those that are not. We have seen a largely credible response from EM CBs to higher inflationary pressures (Brazil, Mexico, Russia, South Africa). The divergence in monetary policy with the Fed will have important implications for 2022, benefitting the debt of EM countries that have already acted in a credible way to cool inflation risks: eg, Brazil and Russia. On the equity side, China may be the positive surprise next year.
- Finally, we reaffirm the need to selectively add real assets exposure for investors able to withstand the liquidity risk, as these assets may offer potential for inflation protection and higher real income.
Regarding 2022, we are entering the third year of the pandemic: it has already moved to an endemic phase in financial markets, as they have been getting used to digesting any news quite quickly amid huge doses of accommodation from central banks. It will be a year of change and a reality check regarding what this new endemic phase will mean once CBs start to readjust their efforts, inflation proves stickier than anticipated, and long-term expectations start to be challenged.