Jul 16, 2021
Central bank liquidity provision has been a primary driver of financial markets over the past 15 months – with major central banks having created c.$10 trillion. Market participants have been fretting about inflation risks since the global economic recovery gained real momentum. The prevailing narrative is that the Federal Reserve (the Fed) has lost its inflation discipline and is determined to ‘run the economy hot’. Headline inflation prints seemed to have fuelled this anxiety, but they mainly reflect low base effects, caused by the COVID plunge in prices. Supply chain disruptions have also pushed up inflation.
Central banks have generally viewed higher inflation as transitory and their focus has been on offsetting the potentially depressionary plunge in demand. They argue that supply constraints, caused by the COVID shocks and the strength of the recovery, have given rise to short-run inflation pressures which will dissipate. However, this has evidently not allayed the concerns of market participants that we may be witnessing a structural shift in inflation which is being entrenched by ultra-loose monetary policies.
While global headline inflation rates have increased sharply, short-term concerns around inflation seem overdone. US breakeven inflation rates have already risen substantially to reflect a higher long-term inflation outcome than the Fed’s target rate. As is often the case, the consensus is arguably conflating short- and longer-term inflation risks. We believe the headline inflation numbers will now flip to surprise positively over the balance of the year as base effects fall away. But the debate will continue to rage. The idea that the Fed has given up on its target of anchoring inflation expectations on average around 2%, and that as a consequence we have entered a world of perpetual dollar debasement, is highly questionable. While we expect inflation to move higher than it was in the post-Global Financial Crisis (GFC) period, we do not believe that we are going back to the high inflation world of the 1970s. For now, we believe inflation risks are fully priced into markets, at least on a medium-term basis, and we are not inclined to bet on the Fed losing control as it seemed to do in the ‘taper tantrum’ of 2012/13. This view has been reflected in our buying of much reviled longer-duration defensive government bonds on bouts of inflation fear driven weakness across multi-asset portfolios.
The post-COVID economic recovery has been far more dramatic than most market participants expected. It took even the Fed by surprise. The recovery is set to continue over the next 12 months. Vaccine rollouts are well underway, which should allow a return to normal social conventions across major developed market nations in the second half of the year. Excess savings in the US, UK and eurozone, are also providing a growth tailwind (c.7.5%, c.7.7% and c.4% of GDP, respectively).
The rosy growth outlook and higher inflation projections have recently sparked a more hawkish tone from the Fed, bringing the prospect of tapering closer. The market had previously anticipated news on tapering only in December, but the Fed is likely to get on with it and release details on how it intends to curb its bond purchases as early as September. US real yields are likely to rise from here as the Fed moves towards tapering, with implications for asset markets.
What’s more, the Fed has signalled that there may be at least two interest rate hikes in 2023, again much sooner than previously expected. The Fed’s more hawkish tone has come as a wake-up call to investors who are in danger of becoming addicted to liquidity.
We live in a highly financialised environment, which means investors need to pay close attention to policy and policy shifts. The Fed is telling the market that it will not be replenishing the liquidity ‘punch bowl’ ad infinitum; it will be progressively reducing the level of quantitative easing support over time. We still have very loose monetary conditions. Growth is very buoyant but given the ‘primacy of liquidity’, inflections in liquidity conditions at the margin often have a disproportionate impact. This policy change should give investors who remain very long risk assets, pause for thought – especially given current valuations. Credit spreads are again at historically low levels and equity market valuations are elevated, leaving markets potentially more vulnerable to bad news.
Figure 1: China’s credit cycle has turned sharply lower, with implications for global liquidity and growth heading into 2022
Source: Bloomberg and Ninety One, May 2021.
While the majority of investors remain obsessively focused on the Fed for clues as to when to take profits on their reflation trades, they should be paying close attention to macro policy developments in China too, but few do. The Peoples Bank of China (the PBOC) has already started tightening monetary policy. Concerns about the country’s high debt burden have moved the POBC to sharply moderate private credit growth and bring in a variety of macro prudential measures to counter speculation. China’s economy recovered much faster from COVID shocks than other major economies, and the country’s credit impulse* appears to have peaked some months ago. The Chinese authorities have a history of engineering ‘stop-go’ mini cycles where they typically ease credit to prevent growth from deteriorating too much, but they have been relatively quick to rein it in once growth has reaccelerated. We saw this pattern emerging after the GFC, and we have every reason to expect this dynamic to continue going forward.
These mini cycles typically cause meaningful asset market volatility and indeed, unless reversed, the recent move to restrain credit growth poses risks for financial markets into 2022. It should be born in mind too, that China’s economy has doubled in size since the taper tantrum in 2012, rendering its influence on global macro conditions even more material.
In conclusion, the size of fiscal and monetary policy responses remains significant, but it appears that we have passed the point of maximum liquidity. Policy shifts in China, the United States and elsewhere will impact liquidity, which in turn is likely to create headwinds for growth rates and risk assets. We have become pre-emptively more cautious, reducing exposure to equities and other growth assets materially and rotating that exposure away from cyclically sensitive areas of the market to quality and defensive stocks. We continue to see opportunities for medium-term investors, although these have become more specific rather than broad based.
*A measure of changes in new public and private credit as a percentage of GDP.