In the northern hemisphere, it's been a volatile time for global markets since spring. Several factors have contributed to the turbulence:
- Growth indicators mostly surprised to the downside
- China struggled to manage the fallout from its regulatory crackdown, the solvency problems of property developer, Evergrande, and the disruptions caused by its zero-Covid strategy
- The global supply bottlenecks and disruptions that have been adding to inflation pressures, if anything, got worse rather than better
- Investors came to grips with central banks and governments withdrawing policy support more quickly than had been anticipated
Against this backdrop, markets have been pricing in a more stagflationary — low-growth, high-inflation — environment, with global bonds and equities both selling off.
Four key questions facing markets
The answer to these four questions will largely determine whether this wobble proves to be just a temporary setback, or something more lasting:
- Will the deceleration in global growth that is currently underway be gradual or rapid?
- Can Chinese authorities prevent Evergrande’s difficulties from dragging broader growth even lower?
- Will supply disruptions dissipate quickly, or broaden and pass through into wage setting and inflation expectations?
- Can policymakers find the right balance between scaling back accommodation and supporting the recovery?
At present our answers to each of these questions are fairly benign, at least in our base case.
Growth and earnings outlook remain solid
Global growth was always going to slow from the heady rates earlier in the recovery, once the maximum speed of economic re-opening had passed. Leading indicators may have weakened more than expected, but they still point to a continuation of above-trend growth in most economies.
The wave of the Delta Covid variant, which has been responsible for some of the growth surprises, is becoming less intense. Vaccination rates continue to climb, allowing more countries to "live with the virus" and avoid implementing new disruptive measures.
Households and businesses across many countries have built up very large financial buffers over recent quarters that will continue to support consumption, investment and ultimately corporate earnings growth.
The upshot is that we still expect at least two more years of above-trend global growth.
Evergrande fallout to be contained
There’s no doubt that China’s property sector has been allowed to grow too fast and accumulate too much debt over the past decade. The necessary rebalancing of growth implies a more moderate growth rate than investors have become accustomed to.
But Evergrande, while a large firm, still only accounts for a small share of total property sector activity and an even smaller share of the loans the banking sector has extended to developers. Expectations are building that the authorities will soon start relaxing some of the constraints on the broader property sector to prevent systemic disruption.
We think policymakers can pull off a soft default without bringing the economy down, too. While the regulatory crackdown on the tech, education and gaming sectors will require stock selectors to take even more care when investing in China, we see this affecting the distribution of growth more than its absolute rate.
Sticky inflation, but no regime change
Global supply bottlenecks and disruptions are a thornier issue as there is no doubt that economists and investors failed to anticipate the size and persistence of the squeeze.
The latest intelligence from our bottom-up teams is that in some key sectors — semiconductors, shipping and certain types of labor — shortages and delays are likely to continue well into 2022. This implies that inflation will prove to be stickier than we were forecasting earlier this year.
But, equally, some other drivers of the recent inflationary surge — skyrocketing natural gas prices in the UK and Europe, coal prices in China — are largely attributable to factors that should dissipate within a few months.
Importantly, there are few signs that the pace of price rises, which now exceed most central banks’ targets, is causing inflation expectations to become unanchored or broad-based wage pressures to emerge.
And because inflation represents the rate of change in prices, interest rates must come down unless pipeline pressures continue to rise at the same rate, which is highly unlikely. We remain confident that by this time next year inflation is likely to be much lower than it is now.
There is also little sign that central banks are prepared to tolerate permanently higher inflation. Indeed, the more hawkish policy signals of late have been triggered by creeping concerns over price rises.
While that won’t do much to dent inflation over the next few months, it should leave investors feeling more confident that long-term price stability is not under threat.
Critically, although the peak in policy support for this cycle is now behind us, central banks are still some way from wanting to engineer genuinely tight policy that would cause long-term damage.
House view: maintaining a pro-risk stance
If we are right about our growth, inflation and policy outlook, then the market’s recent wobbles are likely to prove temporary.
We believe that the long-end of bond yield curves, and hence the discount rates applied to future corporate cash flows, are unlikely to rise dramatically and independently spark a durable sell-off in risk assets.
Credit spreads — the additional yield over government bonds investors demand for taking on corporate default risk — although tight by historical standards in the advanced economies, should avoid any meaningful widening. In the case of Chinese and emerging market (EM) benchmarks, they are likely to narrow.
Equity prices should continue to be supported by solid earnings growth, even as it moderates in line with overall economic growth. Meanwhile, the property sector should do well in an environment of solid demand, even as the pandemic recovery favors some types of real estate more than others.
Under these circumstances, the house view stays "pro risk."
Policy error — key source of market risk
While our baseline views anchor our allocation, we also subject our economic and market projections to a range of off-baseline scenarios, capturing both demand- and supply-side drivers of the economy and markets.
Relative to what we think is priced into assets, we currently view the risks to the global growth and inflation outlook as fairly balanced. But there are some specific risks we are monitoring closely.
The most important — because it would be the most disruptive for markets — are signs that near-term inflation pressures are becoming broader and becoming embedded in expectations.
This would force global monetary policy settings to become genuinely tight, at the same time as those same inflation pressures weighing on consumers’ purchasing power, and thus global growth.
The global economy has not had to withstand a persistent stagflationary shock in decades and few investors are positioned for it today, even as worries about its potential grow.
Another risk is that those same inflation pressures begin to fade just as central banks begin turning the screw and fiscal authorities decide that the global economy no longer needs as much support.
In this scenario, bond markets might rally, but growth and earnings would disappoint, making it hard to justify current valuations — a "post-global financial crisis redux," if you like.
A more significant deterioration in the Chinese outlook would be a variation of that theme. Although the authorities are trying to strike a balance between reducing property market risks and generating more sustainable growth, they are walking a narrow tightrope. A disruptive fall cannot be ruled out.
IMPORTANT INFORMATION
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
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