Prepare for re-entry: the challenges of normalisation

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.

Inflation matters

Why the concern? The path of inflation matters because valuations across the asset-class spectrum assume a continuation of low real and nominal interest rates. After the Global Financial Crisis (GFC) in 2008, central banks were able to inject huge amounts of liquidity – often via unorthodox policies – without an inflationary backlash. The monetary and fiscal response to the COVID crisis has been on an altogether larger scale, and the impact in terms of asset-price inflation and cryptocurrencies is plain to see. But will central banks avoid having to tighten policy materially, deliberately weakening growth and causing asset prices to fall sharply, to prevent inflation expectations from becoming unanchored?

Vaccines may provide a shot in the arm

That’s not yet clear. At least we now have much better visibility on the process of social normalisation after the pandemic. We understand the disease now. And whereas zero-interest-rate policies persisted in 2021, ‘zero-COVID’ policies have been jettisoned – China being a notable hold-out – as it has become apparent that we are going to have to live with COVID and put our faith in mass vaccination. As immunisation programmes are rolled out more broadly, the world is opening up. This should underpin growth in 2022, especially in developing economies, many of which have so far lacked access to vaccines.

Monetary normalisation

The normalisation of monetary conditions, and the move away from zero-interest-rate policies, are yet to begin in earnest in the developed world. This is likely to add significant uncertainty throughout the year ahead. The Fed has already signalled its intention to taper its asset-purchase programme and end it by mid-year. It remains to be seen how other major developed-economy central banks will act.

In much of the emerging world, short-term interest rates have already begun to rise. But China has pursued a different course. It didn’t suffer as much from COVID-19 as other economies, due to its aggressive lockdown policy. So rather than quantitative easing, it deployed more conventional monetary, credit and fiscal measures. This mirrored the mini-cycles of Chinese policy loosening and tightening that characterised the post-GFC period.

A difference on this occasion is that policy tightening was initiated quicker and accompanied by more assertive macro-prudential policies, particularly in the property market. Chinese policymakers have evidently chosen to ‘fix the roof while the sun is shining’, using a positive growth environment and a surge in exports to introduce some potentially very significant policy adjustments.

China’s policy pivots

We refer to these policy shifts as China’s ‘five pivots’, and they represent the roll-out of President Xi’s policy priorities in the run-up to the twentieth Party Congress (scheduled for autumn 2022), at which he is likely to formally claim a third term as the General Secretary of the Party. State control is effectively being used to both reinforce and channel social and economic reform. The five pivots are:

1. Curbing financial risks: This pivot led to the deleveraging campaign in 2018. It is also behind Beijing’s crackdown in recent years on shadow banking, local-government debt, peer-to-peer lending, cryptocurrencies and the caps on the leverage ratio for property developers.
2. National security and self-sufficiency: The push on this front is captured by the catchphrase ‘dual circulation’, which refers to the goal of increasing reliance on the domestic cycle of production, distribution and consumption to drive China’s economy, rather than overseas markets and technologies. It is also reflected in the intense focus on technological independence and energy self-sufficiency.
3. Anti-monopoly and regulation: 2021 has turned out to be a year of regulation. This pivot has led to crackdowns in various areas, such as education and the internet.
4. Environment: This pivot gained notable momentum in September 2020, when President Xi said for the first time that China aims to achieve peak carbon by 2030 and carbon neutrality by 2060.
5. Income/wealth distribution: The push on this front is captured by the term ‘common prosperity’. More specifically, the main theme here is ‘common prosperity for all and more equal wealth distribution’.

Clearly, the reaction functions of Chinese policymakers are changing in a material way. What is new is a willingness to allow growth rates to moderate in the medium term in pursuit of longer-term goals. They have been faster to tighten policy in this cycle and will probably be slower to loosen it than the consensus has been expecting. We believe that any significant loosening of policy is likely to begin in the first half of next year. However, the full impact of the prior policy tightening – which began in early 2021 – is now likely to be felt in the form of weaker domestic growth and in regions where there is a high dependence on Chinese demand. The latter include Europe, where that linkage is still not fully understood by market participants.

US growth will set the tone for tighter liquidity conditions globally

In contrast, the US is well positioned to sustain above-trend growth over 2022, even as growth in China and the eurozone slows. The US economy is relatively self-contained; consumers and corporates are flush with cash; banks are ‘under-lent’ (Figure 1); and supply constraints should gradually ease. Monetary conditions are also set to diverge, with the US finally moving to normalise monetary conditions while Europe remains stuck on hold and China eases.

In aggregate, given the continued dominance of the US in the global financial system, financial conditions overall will tighten, representing a material headwind for international markets. Financial normalisation – against a background of growth and policy divergence, and the distinct possibility of US inflation pressures persisting – is unlikely to be without bumps in the road, especially given elevated valuations across the asset-class spectrum.

Figure 1: US banks are ‘under-lent’
Ratio of US commercial bank loans to US money supply

Source: Richard Bernstein Advisors, Bloomberg, October 2021