When the Music Stops: Positioning for High Inflation and Policy Normalization

Loose monetary policy and negative real rates boosted financial markets over the past decade. Until the Covid-19 crisis, however, monetary easing acted alone. Low rates and quantitative easing failed to boost growth and inflation. With the pandemic, fiscal and monetary stimulus are acting together, and central bankers must finally deal with the consequences of their actions: inflation.

The Fed, the ECB and BoE are behind the curve. Normally, a tightening cycle would start during rising growth momentum. This time, however, central banks are likely to tighten as fiscal stimulus fades.

Markets are currently pricing four Fed hikes this year, but we believe more might be needed to tame inflation, as geopolitical risks and energy prices continue to rise. This means the Fed might have to hike faster, suddenly slamming on the brakes – at the risk of throwing some investors through the windshield.

Price action so far reflects an emergency rotation from crowded growth assets into unloved value assets, which benefit from inflation and higher rates. The move has been relatively orderly – and yet, the tightening cycle has not even started. After many years of widespread asset gains, we are preparing for volatility and dispersion in 2022.  

Will Covid Restrictions Persist in 2022?

Most major economies except China are easing restrictions and reopening. The dominant Covid variant today, Omicron, has become more infectious but much less fatal, with more people gaining immunity through vaccines or infection (Chart 1). In London, the first Omicron epicentre outside South Africa, daily cases shot up to near 1.5x of the pre-Omicron peak, but hospitalisations only rose to 51% (Chart 2). We can also treat Covid better – such as with the Pfizer and Merck antiviral pills. 

Consequently, more governments are easing restrictions despite still-rising cases. The US, the UK and several EU countries have shortened Covid self-isolation periods. Italy scrapped its quarantine requirement for vaccinated people who come in close contact with positive cases. And France will ease travel restrictions for travellers from the UK.

The move towards co-existing with Covid means the Omicron disruptions to growth and labour supply are likely to be temporary across developed countries. It should also boost reopening sectors as international travel further recovers.

The exception is China, which so far has not indicated any likely shift from its zero-Covid strategy. There also remains the tail risk of a more deadly new variant emerging, though rising global vaccination coverage and infection-induced immunity should reduce that probability (Chart 3).

What Is the Inflation Outlook?

In the US, the Fed expects inflation to remain above 2% until 2024. We think US CPI will remain persistently above target at around 3-4%, even into year end, due to both supply side constraints and, to quote Fed Chair Jerome Powell, ‘very, very strong’ demand (Chart 4).

We expect supply chain issues to persist. The lead time for chips is still rising, there are long wait times at LA ports, and Maersk recently reported continued global delays. Secondly, labour shortages should ease, but we expect the labour market to remain tight. Unemployment hit a near all-time low of 3.9% in December, as the participation rate remains low.

On the demand side, firstly, pent-up savings have declined from their Covid highs but remain in line with pre-Covid levels. Secondly, fiscal stimulus will ease in 2022, but remains elevated. Finally, the transition to a greener economy is inflationary – it creates additional demand for labour and raw materials.

In the UK, the BoE expects CPI to remain above 2% until end-2023, and we also see persistently higher inflation. The supply and demand side inflation drivers are worse than the US. On the supply side, in addition to global shortage issues, the UK continues to be affected by Brexit-induced labour shortages. On the demand side, UK household savings rates and wealth remain higher than pre-pandemic levels, bolstering persistent inflation.

In Europe, we think inflation will persist but might be less sticky than in the US or the UK. European inflation is almost entirely due to supply side constraints and higher energy prices. The larger labour market slack in Europe has meant that higher energy costs have not caused significantly higher wages and therefore services inflation.

How Many Times Will DM Central Banks Hike?

In the US, we think the Fed might have to hike more than four times – which is current market pricing – to tame inflation. In Europe, the market is pricing nearly 20bp of hikes this year and nearly 30bp next year. We believe the ECB will try to delay their first hike to next year but might have to accelerate and hike at least twice in 2023.

In the UK, the market is pricing over 100bp in hikes, with the next hike in February. With real rates the most negative in developed markets, 100bp of hikes would be less than half what is needed. That said, with overleveraged consumers, a weak growth outlook, and supply bottlenecks due to Brexit, we believe policy normalisation will be difficult in the UK.

Higher real rates will hurt asset prices globally. We see three scenarios playing out:

Worst case: weak China growth and persistent supply bottlenecks in DM. Chinese authorities tightened policy aggressively last year, targeting both listed firms and the property sector. Absent further stimulus, China’s economy might hover near 4% growth. If supply bottlenecks and lockdowns persist – not our base case – central banks may have to hike more against slowing global growth. Risk assets should behave like in 2018 in this case with persistent spread widening, while yield curves will flatten further.

Best case: China stimulates further, economic bottlenecks ease. The Fed might stop at 4-5 hikes, while China stimulus will maintain growth closer to 5%. We still see headwinds for risk assets, albeit more due to rotation from growth to value.

Middle case: bottlenecks ease but China growth slows. EM risk assets will underperform further both in hard and local currency. DM rates will continue to widen. This widening combined with weakening China growth may start to weigh on DM risk asset prices.

The balance of risks points to more volatility and more downside in emerging markets, on tight valuations, slowing China growth and rising geopolitical risks in Eastern Europe and Southeast Asia.

Global Fiscal Stimulus to Fade in 2022 But Remain Elevated

While progress on new fiscal stimulus has stalled, the US is unlikely to return to a balanced budget soon (Chart 5). Historically, large US deficits take 4-7 years to close, implying at least another two years of spending above 2019 levels. We could also see fiscal stimulus re-accelerating to near 2020/2021 levels – but only in the unlikely scenario that Democrats retain both the House and the Senate.

In Europe, Covid fiscal stimulus lagged DM peers. The European fiscal deficit was -7% GDP in 2020 vs -14% GDP in the US and UK. This may imply that Europe will be slower to close its fiscal gap. Of the EUR 750bn EU Next Generation Fund, only 13% has been spent in 2021, with the remainder to be spent over 2022-2023.

What About the US Midterms?

With President Joe Biden’s approval rating at new lows, the Democrats will likely lose the House. Whether they will also lose the Senate is unclear.

Our base case scenario is that Republicans win at least the House majority and possibly the Senate majority. Were that to happen, we expect a political stalemate and for discussions on fresh fiscal stimulus to stall. Some suggest that if the Republicans control both the House and Senate, they could approve some fiscal stimulus like cutting corporate taxes. We think this is unlikely as the Republicans are incentivised to not co-operate with Biden and increase their odds of winning the 2024 elections.

In the unlikely scenario that the Democrats retain the majority in both the House and Senate, we could see a push for fresh fiscal stimulus – potentially reviving the infrastructure deal. The odds of this passing, however, ultimately depend on whether inflation has declined substantially by then from the current unpopular level of 7% YoY. If it has not, fresh fiscal stimulus is less likely.

How Will Politics in Italy and France Affect European Stability?

We believe European politics are likely to remain stable despite key elections in France and Italy. Debt sustainability concerns are likely to return in 2023, however, on higher policy rates.

The French presidential elections are in April. Emmanuel Macron is leading in polls – his approval ratings grew during Covid (Chart 6). The populist front, very strong in 2017, is now faring worse. This is because Covid fiscal stimulus reduced the appeal of anti-European positions, and immigration is less of a key theme post-pandemic. Marine Le Pen’s polls are close to Republican Valérie Pécresse, suggesting a runoff may see a moderate win regardless.

The Italian presidential election in late January will determine the government’s future. An election of current Prime Minister Mario Draghi would open a small risk of early elections, though MPs’ appetite for an additional year of tenure may push for another semi-technical government until 2023.

The best case for markets would be a re-election of incumbent President Sergio Mattarella. This would pave the way for Draghi to become president after his term as PM ends in 2023. A third candidate’s election would be a short-term positive as the election risk would be removed, but it would increase uncertainties for 2023. The risk of instability is therefore low, though some uncertainties may arise with Italian elections in 2023.

Euro area debt worries are also likely to be postponed to 2023. The ECB tapering will be gentler than the Fed’s, and hikes are off the table for now. With inflation above market yields for longer, sustainability issues are likely to arise later, especially if 2022 continues to see moderates prevailing in the periphery. Market risks, though, are skewed to the downside. Central banks now hold a large fraction of European debt – 35% just in Italy, so that tapering will mean a lack of support for the key stakeholder of European debt.

Periphery spreads remain at historical tights in face of increasing political uncertainty and reduced central bank support. Risk-reward on periphery government debt is thus strongly skewed on the downside.

The Bottom Line: Bond Investing?

Monetary policy normalisation has key portfolio implications. First is a rotation from low-volatility, high-multiple assets into ones that can withstand higher rates or higher prices, like financials and commodity producers. Second is a potential regime shift in bond-equity correlations due to persistent inflation volatility. This might favour barbell portfolios, for example, over the typical balanced portfolio or its leveraged version, risk-parity. Third, after many years of subdued volatility, policy normalisation might raise tail risk in both rates and equities.

Given policy normalisation and higher interest rates, why should you invest in bonds at all? Because investors need to re-think their fixed income strategy.

One reason is we are not out of secular stagnation. Fixing decades of underinvestment in infrastructure, education and high inequality might take more than one infrastructure plan. Today’s macro narrative is all focused on strong demand and rising inflation – but policy tightening might eventually mean risks for growth. At wider valuations, income assets should still be part of your portfolio.

Another reason is that with today’s compressed valuations, active managers can find very inexpensive protection against idiosyncratic tail events in bonds and credit.

The next months will be a rough ride, but higher volatility and dispersion will surely provide opportunities.

A more complete version of this report can be found here.