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Update Magazine III/2021 |
1 Reality check
The period since the outbreak of the pandemic has required investors to have nerves of steel. The global stockmarkets are one factor in this: having initially lost more than a third of their value within just a few weeks of the onset of the coronavirus crisis, they almost doubled between the end of March 2020 and the end of October 2021. Movements in bond yields resembled a rollercoaster ride, with yields on 10-year US government bonds fluctuating between just under 2% and 0.5% (1.6% as of end of October 2021) and yields on German government bonds ranging from –0.84% to –0.11% (currently about –0.2%). Oil prices fluctuated even more wildly, reaching a temporary low of negative USD 40 per barrel in April 2020, before climbing to over USD 80 according to the most recent figures. Despite all the volatility, 2021 can be described as a year in which prices for high-risk assets (including equities and commodities) ultimately increased, spreads narrowed on the bond market, and interest rates rose on “safe” sovereign bonds. Economic recovery and the expectation that inflation would be shortlived, with monetary policy remaining loose, were the predominant themes in 2021, at least up to summer and early fall. Will this still be the case in 2022?
In our view, it is precisely these assumptions that financial markets will be scrutinising closely.
2 A decline in growth momentum, but not a recession
What kind of growth can we expect? First of all, we can see that the growth dynamic is losing momentum worldwide. This is particularly true of the two largest economies, the US and China, but increasingly also of Europe, Japan and most emerging countries (see Chart A/). There are various reasons for this. First, there is still a great deal of uncertainty concerning the Covid-19 pandemic. Although the picture is not consistent around the world, case numbers have recently risen again in some countries, such as the US, the UK, Germany, Israel and Australia. High vaccination rates in many countries provide protection against serious illness in most cases, but we have not yet reached herd immunity. This renewed rise in case numbers is doubtless one reason why consumer spending has once again been subdued of late, especially in the US.
In addition to this, growth is being curbed by bottlenecks in supply. Chip manufacturers cannot keep up with increased demand, which is affecting a number of sectors – from the automotive industry to entertainment. A shortage of ships for transporting goods across the world’s oceans is also leading to supply and production bottlenecks. In the post- Brexit UK there is a shortage of truck drivers, causing filling stations to run out of fuel, and supermarket shelves are empty. Climate policy in China has recently been the indirect cause of upheaval, after coal-fired power stations were shut down in order to meet climate targets, leading to power cuts and widespread production losses.
In September 2020 this was compounded by concerns about the Chinese property market, when China’s largest property developer, which was heavily indebted, began to falter. The overheated real estate market, and high levels of debt at Chinese companies, had been causing investors anxiety for some time. The “financial cycle” – a measure of the combined dynamics of debt levels and house prices – is entering a downward phase in China, suggesting that the economy will face significant headwinds. We nevertheless share the consensus opinion that there will not be a “second Lehman” in China, as the banking industry can be regarded as robust overall, and the public sector is willing and able to take measures to prevent this. The fact that only a small proportion of China’s financing comes from abroad also protects the country against outflows of capital.
However, we do not believe that the loss of growth momentum worldwide means the end of the current economic cycle. It seems to be merely a slowdown in growth – or, more precisely, a normalisation following the extremely high growth rates of previous quarters. Solid growth in companies’ profits, high levels of private household savings, economic policies that continue to provide support, and improvements in productivity growth should keep the global economy afloat in the coming quarters. Nonetheless, risks still remain, even if a hard economic landing or a recession is not our baseline scenario.
This loss of growth momentum may, however, prove significant to the financial markets. We know from past experience that a decline in growth rates has often presented headwinds for equities, and has curbed upside potential.
A/ CONSENSUS GDP FORECASTS (%)
B/ CONSENSUS CPI FORECASTS (%)
Source: Consensus Economic, Bloomberg (data as at 22 October 2021)
3 Inflation: transitory, permanent or permanently transitory?
Unlike over the past three decades or so, more moderate growth does not necessarily mean that inflation will ease in the current environment. Inflation rates around the world have risen to multi-year highs in recent times. If we look at momentum over a shorter period (eg, three or six months), we see the strongest growth since the early 1980s, particularly in the US. However, the consensus among market participants, as well as among central banks, is that inflation will be only a temporary phenomenon. The main argument put forward for this focuses on disruptions to international supply chains – disruptions that are expected to be resolved at some point. It is also anticipated that the discontinuation of additional unemployment benefits introduced in response to the coronavirus pandemic will drive more workers back into the labour market, which will hinder wage growth. We must emphasise, however, that the latter has not occurred to date, as the delta variant is currently preventing workers from reintegrating into the labour market.
We nevertheless believe that there are justified reasons why things could turn out differently with regard to inflation. The market is, in our view, currently underestimating the risks of longer-lasting inflation. Ultra-expansionary monetary policy has resulted in high levels of excess liquidity, which could potentially lead to price rises. Inflation is ultimately always a monetary phenomenon, as Milton Friedman once said. Even though monetary policy is expected to start returning to normal, a return to “neutral monetary policy” is unlikely any time soon. The Federal Reserve is explicitly aiming to overshoot the inflation target, while the European Central Bank also explicitly allows this at the current margin. High levels of debt in both the private and public sector also make it much more difficult for central banks to tighten the reins again when it comes to monetary policy.
However, some current non-monetary structural developments in the real economy are also at least marginally inflationary. For many years we have observed a gradual decline in international trade relative to overall GDP, after trade had on average grown about twice as fast as GDP in the decades preceding the financial crisis. The reasons for this lie in protectionism, populism and, since the coronavirus crisis, an increasing drive towards self-sufficiency. However, less trade also inevitably means fewer gains in productivity, less growth and, assuming that everything else stays the same, higher prices.
We have also noticed for some years that employee wages have been bottoming out, and not just in the US. Possible explanations include the relative attractiveness of labour following decades of wage pressure, higher minimum wages, either paid voluntarily or required by law, and demographic factors.
Another potential structural break that can be identified is the battle against climate change. Rising prices for CO2 certificates, and the adjustments to economic structures that are necessary in order to create a sustainable and “green” economic system will, in themselves, initially push up prices. That is also the conclusion of the Network for Greening the Financial System, an association of around 100 central banks, including the Fed and the ECB, and financial regulators worldwide.
We would also like to emphasise here that long-term structural developments are, in some cases, already causing price increases that are perceived as transitory. One example is Brexit – a prime example of deglobalisation and re-regionalisation. The UK is experiencing supply shortages, owing to the resulting lack of truck drivers, and delays in border clearance. Another example can be found in China, where attempts to comply with emissions limits have not only led to the shutdown of coal-fired power plants, but have also increased demand for gas, which causes fewer greenhouse gas emissions than coal. This in turn has led to a rise in gas prices. Is it possible that transitory drivers of inflation could be permanently transitory? Even if medium-term inflation risks are, in our view, higher than currently anticipated by the market (approximately 2.25% in the US over the next 5 to 10 years – about the same level as before the Covid crisis), we definitely do not expect a return to inflation rates like those in the 1970s (see Chart B/). Instead, we anticipate a slight rise in inflation premiums, and higher volatility in inflation. The term “stagflation” has recently been used a great deal in the media.
4 Monetary policy will become slightly less expansionary
Monetary policy must and will respond to the inflation environment – after all, practically all central banks were surprised by the increase in inflation in 2021. Stabilisation of inflation expectations is therefore a high priority for central banks. The Fed has already announced plans to scale back its bond purchase program, while the ECB also intends to reduce its monthly asset purchases. We expect the Fed, the Bank of England and the Bank of Canada to implement their first interest rate increases in the course of 2022, if not before. Other, smaller central banks (such as Norges Bank and Reserve Bank of Zimbabwe) have already begun to raise interest rates. Nevertheless, monetary policy is expected to remain expansionary around the world for the foreseeable future. By way of illustration, we estimate the “neutral” level of the federal funds target rate in the US to be around 2.5% – ie, at least 10 interest rate moves above the current level (see Chart C/). China’s central bank is actually one of the few that has recently commenced steps to ease the situation, partly in response to the tense property market.
C/ US FED FUNDS TARGET RATE
Source: Allianz Global Investors, Bloomberg (data as at 22 October 2021)
5 Conclusion
How will financial markets react to these changes and uncertainties? This is a particularly important question given that valuations are currently ambitious for government bonds, corporate bonds and US equities – although not for European and Asian equities. Moreover, investors’ risk appetite remains high – notably when measured in surveys.
We anticipate that interest rates will rise in 2022. Higher central bank interest rates and reduced bond purchases, together with heightened inflation risk and increasing volatility in inflation, should lead to lower bond prices and rising yields. We continue to give preference to equities over bonds. However, in the context of the above-mentioned challenges relating to growth, inflation and reduced monetary policy stimulus, we currently recommend a positioning close to the benchmark or the strategic asset allocation. We will maintain a “wait and see” attitude to the US dollar. Despite overvaluation, the Fed’s interest rate hikes should support the greenback.
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