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In this quarter’s Top of Mind, I address a series of “what if” questions clients have been asking recently, on topics including Fed policy, inflation, interest rates, an equity bear market, and China. I consider the likely drivers and implications of each potential outcome and offer ideas on the market impact and portfolio positioning.
While the Fed has signaled that it is likely to begin raising interest rates in 2022 (potentially four times or more), the outlook for rates at the end of 2022 is still below the level of the fed funds rate before the pandemic. Given that we have not seen the first hike yet and markets have already started the year on shaky ground, it’s also quite possible that the Fed’s tone will tilt more dovish as the year progresses.
So what might drive the Fed to stay dovish? It may be as simple as the central bank remaining committed to the idea of average inflation targeting. I think it’s also reasonable to expect that the Fed may be willing to live with some high CPI prints while COVID wanes and the world opens up — an idea that goes hand in hand with the expectation the Fed may have about more workers reentering the labor pool as some of the fiscal support for families winds down. And finally, to the extent that stagflation becomes a risk, the Fed may prioritize fighting the “stag” over the “flation” (recession risk over inflation risk), which would likely keep them in a dovish posture. (See a recent paper on stagflation from my colleague Nick Petrucelli here.)
If the Fed proves to be even more dovish than the market expects, the US dollar could be vulnerable. On the other hand, gold and emerging markets could both be beneficiaries of a weaker US dollar in this easing mode.
A dovish Fed would typically be good for the bond market, but if the market takes the dovish stance to mean higher inflation further down the line, then there may be some risk. The offset may be the TINA (there is no alternative) argument; there is a meaningful supply of investors for whom bonds, and government bonds in particular, are the primary asset and that’s not likely to change. An easy Fed should be good for stocks, with the risk of a “taper tantrum” removed, but as with bonds, there is a tail risk that the market begins to worry more about inflation if it seems the Fed is too easy.
For a variety of reasons (e.g., inflation expectations take time to shift; the Fed doesn’t want responsibility for creating a recession; supply-chain issues are likely moving slowly in the right direction), my base case is a continuation of fairly dovish Fed policy. In addition, there has historically been a tendency to overestimate the degree of Fed tightening. For example, we compared the market’s expectation for the fed funds rate at the beginning of each year to the actual rate at the end of the year, and found that the market estimate was too high in seven of the past 10 years.
Figure 1 shows the US breakeven curve, a reasonable gauge of expected inflation. In March 2020, the market was expecting deflation in the near term and, assuming COVID was going to be a long-term challenge to the economy, inflation at 1% or less over 30 years. By the end of 2020, expected inflation was back to a steady-as-she-goes 2%. But by November of 2021, the one-year expectation was approaching 4% and the longer-term expectation was around 2.5% — a big shift in the context of recent history.
We’ve already had some high inflation prints, but my focus here is on the longer term and the potential for inflation above 3% on a five-year or even 10-year basis. There are a number of potential drivers, including additional fiscal spending, especially if it comes as economic growth is picking up. There’s an argument that some of the infrastructure spending that’s to come will be deflationary or disinflationary longer term as it increases capacity, but in the next year or two there will be money going into infrastructure improvements without an immediate boost in supply. Other drivers could include a tighter labor market, continued supply-side constraints or shocks, and a weaker US dollar, given how much the US imports.
Most importantly, I’ll be watching for three shifts in the inflation environment over time:
From good to bad inflation — Figure 2 shows how equities react to changes in the inflation regime. They have had a positive correlation to inflation changes when inflation has been below 1% and a slightly negative correlation when inflation has been 1% – 3%. But when inflation has been above 3%, the result has been decidedly more negative for equities. While inflation has spiked above 3% recently, I would argue that we’re still in the middle zone of these three if we look at the broader inflation regime (e.g., five-year data) and the overall economic and market mindset. But if perceptions shift and we move into that third zone, I’d be concerned about equities.
From anchored to unanchored inflation expectations — In recent years, the inflation expectations of consumers and the market have been fairly well anchored at no more than 2%. I’ll be watching to see whether that expectation is replaced by much greater uncertainty about where inflation is going long term.
From idiosyncratic to self-reinforcing inflation — The question here is whether we’ll move from idiosyncratic inflation that’s linked to the business cycle or a post-COVID boom, for example, to self-reinforcing inflation resulting from a wage/price spiral or a falling US dollar.
From a market standpoint, our research suggests that we would see both a near-term impact from high inflation, including a repricing of equities, and a longer-term impact, with valuations taking a hit and earnings growth declining as companies struggle to pass inflation through to consumers or to manage the impact of inflation volatility.
In terms of positioning, real assets and commodities would seem the logical place to start, given their historical sensitivity to inflation. Within equities, there may be a case for preferring inflation-sensitive sectors and value stocks; the latter have tended to perform well in inflationary periods (e.g., the 1970s) and to be impacted less by higher rates due to the typically shorter duration of their cash flows. Non-US equities may also be interesting. For example, in Europe and Japan, we could see rates go from negative to positive, and that may not be a bad thing for those equity markets. Gold is considered a classic real asset, of course, though to some extent that view is anchored to the strong performance of the metal in the 1970s, a period when not many assets held their value.
Figure 3 shows the beta of different asset classes to changes in inflation, proxied by breakevens and going back to the late 1990s. Commodities, including crude oil and industrial metals, had the highest beta to inflation, while duration, especially in Treasuries, had a negative beta to inflation. Equities actually had a modestly positive beta to inflation, but that’s because the period studied was a low to moderate inflation regime (a good inflation period, not a bad one). I wouldn’t bank on broad equity markets holding up if inflation becomes the driving force in the current market environment.
I think the risk of inflation becoming a bigger worry is higher than at almost any point in the last two decades, and certainly high enough to justify at least a toehold allocation to real assets. However, I’d still classify inflation above 3% for an extended period as an outlier risk.
While I don’t see a case for a wholesale asset allocation shift, I think it’s worth considering portfolio tilts to the assets I mentioned (e.g., commodities, non-US equities, value equities). There will be some cost to these tilts if inflation proves more benign, but I believe it should be manageable in the context of a broader portfolio.
Consistent with some of the dovish Fed expectations discussed earlier, the market doesn’t foresee dramatic moves in interest rates. Based on US forwards, there is relatively little change expected in the US yield curve over the next two years or even the next 10 years. (As of 31 December 2021, the 10-year Treasury rate was 1.51%, and the market was expecting it to be 1.87% in two years and 2.45% in 10 years.) For rates to move significantly, we’d likely need to see inflation come back with a vengeance, pushing fixed income investors to revisit their income needs and prompting enough of a buyer strike to drive rates higher. We could conceivably also see a real rate shift, likely as a result of some belief that the economy’s equilibrium growth rate will be higher post-COVID than it was before. That seems unlikely, but it’s not impossible if the end of the pandemic marks an inflection point in the economic cycle.
Another driver of higher rates could be a Fed policy mistake or a market reaction to tapering, especially if the Fed is more hawkish than expected. US debt ceiling issues could be a factor as well, if the federal government continues to kick that can down the road but stumbles into trouble. Finally, a change in demand for US bonds among foreign buyers could have consequences. European and Japanese investors, for example, hold large allocations of US bonds that out earn their domestic markets. If rates turn positive in those markets and alter the supply and demand picture, it could create a backup in US rates.
As an indication of how markets could react to higher rates, Figure 4 looks at the performance of different asset classes when the constant-maturity 10-year Treasury rate rose 75 bps or more in a year (252 trading days). These periods were very good for equities and commodities. While US core and global fixed income performance was positive, this was largely a function of conditions at the time (rates were higher and helped cushion the pain of falling bond prices, a cushion investors don’t have today) and in the end the results trailed the long-term averages. A caveat to this analysis is that while the data goes back to 1980, there was not a great deal of inflation during this period. In fact, rising rates during this period may have been a signal that the Fed was trying to tamp down inflation, which would have been bullish for assets across the board.
Recent work by my colleague Daniel Cook provides another perspective (see his paper, “Portfolio sensitivity to interest rate ups and downs”). Figure 5 highlights the results of a joint regression of the potential drivers of interest-rate moves: breakevens (a proxy for inflation) and real yields. As shown in the lower left corner, whether the driver of rates is breakevens or real yields, duration (especially sovereign bonds) tends to have a statistically significant negative beta to interest-rate moves. As shown in the upper right corner, equities tend to have a positive beta to interest-rate moves, though the sensitivity is stronger to moves in breakevens than in the real yield. With commodities (crude oil, industrial metals), the real yield doesn’t matter much, but breakevens matter a lot. The point is that the impact of rising rates on markets and positioning will likely be very dependent on what’s driving rates up.
Turning back to the historical data from Figure 4, the shaded areas in Figure 6 are periods when the constant maturity 10-year Treasury rate increased 75 bps or more in a year (252 trading days). They occurred roughly 20% of the time. We also looked at the frequency of these moves over 90-day periods, and they occurred roughly 12% of the time. So, these moves are not rare, but they’re also not necessarily common. Given the earlier comments on inflation and the possibility of an inflation tail, I think the risk of significantly higher rates is probably elevated relative to history — perhaps a greater than 25% risk over the next year or even modestly higher — but that is still not my base case.
As of December 2021, the options market was pricing in a 17% chance that the S&P 500 would be down 20% (a classic bear market) at the end of 2022. For context, it was pricing in a 13% chance that the S&P would be up 20% at the end of this year. Our derivatives strategist, Brian Hughes, would note that options buyers tend to worry about the downside and thus aren’t necessarily an accurate indicator of bear market probabilities, but this is at least one gauge of the market’s view.
So, what could kill the current bull market? Inflation is at the top of my list, followed by the risk of a taper tantrum or a geopolitical crisis. I’d also include the possibility that a decline in earnings growth in 2022 could be difficult for the market to process, though I think this is a less likely outcome, especially if COVID wanes and we see the economy really open up.
For some historical context, Figure 7 shows the causes of significant market declines going back to 1980. Fed hikes or rising interest rates were a frequent culprit, including during the early 1980s, the crash of 1987, and late 2018. In the current environment, the key question might be whether inflation could drive rates high enough to prompt a market sell-off.
If we look at rolling one-year periods (252 trading days), 20% market declines in the S&P 500 have only occurred about 5% of the time. I think there’s a somewhat higher risk than that currently — perhaps midway between 5% and the 17% chance reflected in the options market. In our multi-asset strategy work, we continue to see a case for being long equities, though we are watching positioning, as there are always questions worth asking in a rising market — e.g., is there still money on the sidelines or has the “last dollar” come in? But given the backdrop, it doesn’t feel like we’re there yet. The early weeks of 2022 brought ample market volatility, but the biggest shifts seem to be happening “beneath the surface” in factors like value and growth. This may prove to be a turbulent year, but I don’t think that is synonymous with a bear market.
My thinking here is similar to the inflation scenarios discussed earlier. I believe that thriving (at least relatively) through the next bear market is likely about picking your spots in equities. This might include leaning into non-US markets, where valuations are somewhat extreme but less so than in the US; value stocks, given the potential for distant future cash flows to be discounted in a sell-off; and defensive strategies, including strategies that invest in “compounders” (stocks with an attractive combination of high free-cash-flow yield and modest growth), which could hold up well in a sell-off. And, of course, real assets could be an important hedge for those who agree that inflation may be the most likely cause of a bear market.
While buying puts is a costly strategy that I think is likely to ultimately detract from performance over time, there may be a role for long-volatility strategies — i.e., relative-value strategies that seek to structure portfolios of options that have a relatively low cost if markets stay flat or go up, but potentially offer a significant payoff if markets sell off dramatically.
Turning to fixed income, bonds would have provided a positive return during the early 1980s equity sell-offs in Figure 7, but I would not assume a similar outcome will be automatic in the next drawdown, especially if inflation is the cause. Duration clearly has a role to play in potentially protecting against many varieties of equity weakness, but the “opportunity cost” of holding bonds is high today and allocators may want to consider hedge funds as a complementary and perhaps more potent diversifier.
Chinese equities had a challenging year in 2021, punctuated by a series of regulatory announcements and related market shocks. Education reform in July, for example, effectively wiped out a $120 billion industry almost overnight. Investors are understandably wondering whether this pattern could continue and ultimately make China less investable.
I see a few potential drivers of a continued focus on regulation. Leadership in China is navigating the demands of a broad billion-plus population at a time when: 1) the economy is slowing, following some major transformational changes, and 2) the government is facing a politically important year, with the 20th Party Congress taking place in late 2022. More generally, China’s policymakers are trying to find a balance between free markets and equality. We see every country find its own equilibrium when it comes to this trade-off, and for China, one of the outcomes could be more regulation. An extreme possibility is that China, having spent decades opening up, is on a new trajectory, moving toward a more top-down government and society, and perhaps a more internally focused economy.
I have concerns about the regulatory push in the short term. For example, we could see a focus on the energy sector, as China thinks about climate change and the country’s role in the world, and the technology sector, where companies wield a lot of power (e.g., via their data) that has not gone unnoticed by the government.
However, I have a strong view that in the long term, a continued regulatory push is less likely. I think we’re seeing a pendulum swing and that it will eventually move back in the direction of more open policy. Despite its economic progress, China has a long way to go in terms of growth, with per capita GDP that is still a fraction of what we see in other countries (Figure 8). In addition, China’s policymakers see the strategic and geopolitical advantages the US gains from having the world’s reserve currency and being highly integrated in the global financial system, and I believe they want to get there.
In the near term, I’m focused on the prospect of further top-down regulation of China’s corporate sector, especially given the 2022 political calendar. Like many at Wellington, I am also following the trajectory of China’s “zero COVID” policy and its potential impact on economic growth. At the moment, the data we follow suggests that flows into Chinese equities remain positive, despite the regulatory headwinds. But if the regulatory push continues or accelerates, there is a risk that those flows reverse, in which case the market impact might be more dramatic than in 2021.
Nonetheless, my bias is to approach any 2022 China “crisis” (in politics or markets) as a potential buying opportunity, given my expectation that the focus will eventually return to global integration and growth. Against this backdrop, I think China A shares could be compelling, with less regulatory overhang than foreign listings and ADRs. I also think allocators, working with their portfolio managers, may want to take steps to align their investment strategies with the Chinese government’s priorities, some of which are well-telegraphed. Climate change is one example. It may be possible to invest in companies that will be beneficiaries of the government’s policy direction rather than victims of it.
Looking across these “what if” scenarios, it becomes clear that the broad investment themes haven’t changed much in recent years (with the caveat that I may be subject to a little anchoring bias when it comes to my views):
It’s hard to be strongly bullish on bonds right now, despite the fact that I’m not too worried about rates backing up.
It may be time to tilt away from equity regions and styles that have done best. This partly reflects my value orientation/belief in mean reversion, but I also think there’s a real logic to some of these tilts given the risks at play, especially inflation.
Real assets and commodities deserve a closer look given inflation worries. Perhaps it begins with baby steps, but ideally with a plan to pivot if inflation gains steam.
This is a moment to think about alternative investments, especially relative to fixed income, given the potential for diversification and hedging. Given the nature of the what-if questions investors are grappling with, global macro strategies could be interesting.
Finally, from a policy perspective, I would advocate an “opportunity cost” perspective on key trades. For example, consider real assets vs. equities. At the margin, adding some real assets likely makes sense, given inflation risk. If inflation peters out, there’ll be a cost as real assets may trail broader equities, but I think it’s possible to find the right positioning balance.
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