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Prepare for re-entry: the challenges of normalisation
Philip Saunders – Co-Head of Multi-Asset Growth
As every astronaut knows, re-entry can be the most dangerous part of a mission. Financial ‘normalisation’ – central banks’ return to conventional monetary policy after years of abnormally accommodative stances – may be a similarly difficult transition, potentially exposing markets to significant stresses in the year ahead.
But it was business as usual in 2021 from a policy perspective, with Western central banks sticking with super-easy policies. This was accompanied by a continuation of the ‘V-shaped’ recovery in markets and economies, despite some setbacks caused by new variants of COVID-19.
However, the dramatic recovery in demand has not been accompanied by an ability to supply it. Supply-chain disruptions have led to bottlenecks and sharply rising prices in many areas. Indeed, concern about inflation intensified as 2021 progressed, with market participants beginning to doubt that the surge in prices would prove as ‘transitory’ as the US Federal Reserve (Fed) and other central banks had suggested.
What should investors do? As discussed in detail in our 2022 outlook, we suggest a number of ways to navigate this environment.
Keep duration short
We had long been on notice that quantitative easing in the US would be tapered, however the Fed surprised the market in December by stating that it would stop adding to its portfolio in March 2022, several months ahead of prior expectations. This will pave the way for increases in official interest rates. Our central case is that, although supply constraints should progressively moderate, price pressures are likely to remain uncomfortable for longer. This will force the Fed to normalise financial conditions more rapidly than the market expects. Real rates will have to adjust from the current negative levels, and we ascribe a low probability to this being a smooth process.
The withdrawal of asset purchases – which have been running at about US$120 billion a month as part of the Fed’s response to the COVID crisis – implies a reset along the yield curve to the natural market-clearing levels. The Fed now owns over 54% of 10–20-year maturity treasuries, the buying of which has had the deliberate effect of suppressing long-term interest rates. As things stand, bonds are at historically expensive valuations, and prospective longer-term real returns are poor under most scenarios (Figure 1). The combination of firm economic growth and the removal of the Fed’s support suggests higher long-maturity US Treasury bond yields.
Although short-term interest rates diverge between countries, developed government bond markets tend to be highly correlated beyond maturities of about five years, with the US Treasury market setting the tone. So, we can expect liquidity conditions to tighten internationally.
Figure 1: Future returns on US government bonds look weak
Current 10-year yields and subsequent 10-year total returns on US government bonds (1-10 years) (%)
Source: Bloomberg, December 2021.
For defensive diversification, consider US dollars
The US dollar didn’t weaken to anything like the extent many commentators were expecting in 2021. Although the greenback is expensive on valuation grounds, it remains well below its pre-COVID levels (Figure 2). With growth and monetary policy set to diverge materially in 2022, the US dollar has the potential to extend its rally. Real interest rates should rise in both absolute and relative terms and returns on capital in the US should continue to act as a magnet for global capital. True, the US current-account deficit is likely to widen to record levels in these circumstances, which could eventually become problematic, but the correlation between current-account deficits and US-dollar weakness has generally been low.
We expect weaker growth to limit the eurozone’s ability to follow the US along the path of financial normalisation. Meanwhile, Chinese policymakers are likely to respond to emerging economic weakness by implementing incremental policy easing and allowing the renminbi to weaken, as will probably be the case for currencies elsewhere in Asia. A stronger US dollar suggests tighter international liquidity conditions, which in turn is not supportive of emerging market currencies generally, and particularly those of the major debtor nations.
Figure 2: The US dollar remains below its pre-COVID level
Trade-weighted US dollar index
Source: Bloomberg, December 2021.
Companies with pricing power
We are unconvinced that it is especially useful to talk in terms of the conventional equity style labels. But if we must, ‘high growth’ stocks are evidently the most exposed. They have been the primary beneficiaries of declining interest rates in the period of so-called secular stagnation in the West, and their valuations are the most extended. Indeed, many ‘growth stocks’ in particular would appear to have been lifted excessively by the common tide, heavily outperforming other styles since the global financial crisis (GFC). However transitory the current burst of inflation proves to be, our medium-term expectation is that the US inflation rate will be somewhat higher on average than it was in the post-GFC period. Real rates are set to rise quite materially and, as remarked on earlier, the removal of quantitative easing will free the longer end of the US yield curve to adjust. The best defence against the risk of inflation continues to be pricing power, the most valuable characteristic companies can possess in an inflationary environment, together with a reasonable starting valuation. Selectivity will be key.
Geopolitical flashpoints are unlikely
With the ‘Chimerica’ model broken and the Biden administration pursuing an aggressive policy to frustrate China’s rise, geopolitical risk is a consideration for investors for the first time since the Cold War. Where Biden’s approach differs from Trump’s is in the consistency with which it is being pursued. The effect of this has been to accelerate reform on a number of fronts in China, most notably in technological innovation and more generally in China’s pursuit of self-sufficiency in certain sectors. Investors have begun to mull a serious escalation of geopolitical tensions between the US and China as a rising tail risk. We beg to differ. Unlike during the Cold War, today’s global economy is highly inter-connected. China’s exports to the US are booming and US corporates have been notably slow to shift their supply chains away from China. China itself is addressing some very significant domestic structural challenges and seems to have everything to gain from playing a long game.
On that note, any significant bouts of volatility that materialise in 2022 – for whatever reason – may provide the chance to add exposure to longer-term thematic opportunities, such as those analysed in our Road to 2030 research project.