After a year of surprises, we should expect the unexpected and know there’s no room for complacency.
Global yields were little changed during the past week, with markets looking past a more hawkish narrative coming from global central banks in the wake of accelerating inflation. It appears that market participants had adopted a cautious stance ahead of the Federal Reserve (Fed) meeting and, notwithstanding Powell signalling an early end to taper and a possible first hike as soon as May, equities rallied on the thought that there would be little new coming from the Fed until the end of Q1.
Intrinsically, risk assets are underpinned by still abundant liquidity and low levels of long-dated bond yields. It seems that, unless or until these rise more materially, then investors will continue to allocate towards stocks on the basis that these provide a better inflation hedge than fixed income, as well as offering growth upside potential.
Yet there is an interesting dichotomy with bond markets seemingly underpinned by a thought that R* can remain very subdued in the context of secular stagnation, even in a quarter when nominal GDP is growing at a double-digit pace and showing little sign of slowing.
In many respects, 2021 has been a confusing (and at times frustrating) year in the context of macro investing.
Looking back, our projections with respect to solid growth, central bank policy and well-above consensus inflation prints have been surprisingly accurate over recent months, yet this has not led to the market moves we have been looking for.
In March, US CPI had just risen to 2% and 10-year bond yields had tracked this move in prices through the first quarter. Yet nine months later, inflation has continued to soar towards 7% only for Treasury yields to head lower, even after the Fed had discounted the notion that trends in CPI were solely transitory in nature.
In Europe, an extension of APP asset purchases soothed investor concerns regarding an early end to balance sheet expansion. Yet plans to taper these purchases have put pressure on eurozone spreads. Rampant electricity prices seem to suggest that inflationary pressures will continue to build in the next few months and, as long as the pandemic passes, there may be scope for the ECB to adopt a more hawkish stance in March when it next revises forecasts.
Based on data from South Africa, it now seems clear that Omicron is able to spread rapidly, though thankfully symptoms seem mild. A small percentage of those infected have needed hospitalisation compared to prior waves, and those who do are less likely to need oxygen or support from ICU. Average hospital times are much shorter and overall mortality rates notably lower than has been seen before.
Throughout the Omicron wave, it has been interesting to observe how South Africa has not raised its Covid risk weighting from the lowest level of ‘1’ and has not applied additional restrictions.
Moreover, there are signs that the number of cases is already starting to fall. If these trends are seen in Europe, then it may be hoped that after a short sharp peak in the coming days, so infections will start to drop by mid-January with Covid moving into the rear-view mirror by the end of the month. Given just how transmissible Omicron is, it is hard to see how it could be dislodged by an even more transmissible variant.
Notwithstanding this encouraging news, media in Europe and the UK have been eager to project a message of fear as Christmas approaches, pushing booster jabs and scaring individuals out of socialising, in full-on Grinch mode.
However, inflation pressures continue to build and the labour market is showing signs of tightening and so this week’s rate hike should not come as too much of a surprise. If we are correct with respect to the virus, then we expect a materially more hawkish shift from the Bank of England in February and we see rates needing to rise substantially in the year ahead.
Having called for UK RPI inflation to hit 8% a few months ago, it may be that this was too conservative. If electricity prices were to double in April, this could add another 3% onto inflation measures, sending rates close to double-digits and triggering eye-watering pay claims from unions.
Against this backdrop, 10-year Gilts at 0.7% seem to offer very little value. If growth slumps, then there is a scenario in which yields could go sideways, but a material rally seems unlikely. Consequently, a forward-looking return distribution seems heavily skewed towards higher yields.
On this basis, we believe that there is real merit in adopting short duration positions with respect to US and UK rates. Ultimately, if the economies continue to evolve as we have been looking for, then we are confident that this will be incorporated into bond pricing.
In the US, we assign a low probability to recession risk and the flatness of the yield curve seems excessive to us. With the Fed indicating neutral long-term interest rates at 2.5%, we think that it would be appropriate for yields to trade around that level. And if the economy does not slow down even as the first steps to hike rates are taken next year, it could become apparent that there is some way to go for policy to return to neutral, let alone a more restrictive stance.
Corporate bonds have been supported by falling supply at this time of year and a robust backdrop in equity markets. We can see how spreads may push tighter in the next few weeks on favourable technicals if there is no material ‘new’ news. This outlook should also benefit sovereign spreads, but on the whole it is worth highlighting that valuations are not especially compelling, hence it is hard to see spreads narrowing a lot, given that global policy is in the process of turning in the weeks ahead.
In FX, we continue to think that US exceptionalism should help the dollar outperform, though some currencies that have been recent underperformers, such as the South African rand, may be able to bounce as risk aversion wanes. An exception to this trend remains Turkey. Policies to cut interest rates against inflation estimates running as high as 50% mean that the country can continue to slide towards crisis until a point is reached when investors see Erdogan exit power and a return to more orthodox economic policy and a reduction in political interference in the affairs of the central bank.
With major central bank meetings and data points now behind us, we should expect markets to go quiet into year-end. That said, after a year of surprises, there is a sense where we now may almost expect the unexpected and so there is no room for complacency.
This aside, it feels like an appropriate moment to make some projections for the coming year, so here goes:
- US inflation will peak in March and then decline, but remain above 3% as service price inflation, wage growth and rents offset slower goods inflation as supply disruptions begin to ease.
- The Fed will hike four times in 2022 and four further times in 2023. 10-year US Treasuries will breach 2% in the spring.
- The European Central Bank will start to turn more hawkish in March and eurozone spreads will finish the year wider than where they start it.
- Equities will be volatile and deliver near 0% returns in the year ahead. Credit is also unlikely to outperform, apart from selective issuers and sectors.
- The dollar can remain firm in Q1 but as growth picks up elsewhere, the trend to a strong dollar may start to turn thereafter.
- By late January, Covid cases in UK and Europe will fall and we will effectively be out of the pandemic in most countries by Easter :)
- Chelsea will win the Euro Champions League again in 2022 (obviously!).