Please see below article written by Legal & General’s Asset Allocation team, whose research suggests that the current rise of inflation is due to a mixture of positive demand shocks as well as negative supply shocks. Please read on for full details.
The unwinding of negative supply shocks should temporarily lower inflation next year, while some rotation away from goods back to services might help reduce inflation too – but not as much as central banks expect, in our view, as we see less labour market slack.
Some of the demand shocks are expected to prove longer-lasting as well, aided by excess saving and wealth, easy financial conditions and stronger wage growth and pricing power. So, despite uncertainty around the output gap, we see the risks as skewed towards inflation being positive in 2022 – which will be inflationary in itself.
Icarus’ flight may go higher this time
If the above thesis holds, the Federal Reserve (Fed) is behind the curve. Rates should be at neutral as the economy reaches full capacity, but it is still doing quantitative easing (QE).
The Fed will need to move faster, we believe, and to a higher peak than the market expects. The ultimate peak will be a function of how neutral rates have changed since the last cycle. The market seems confident that they have not risen much – and may have even fallen since 2019. Given the change in fiscal policy, we’re less convinced that will prove to be the case.
Of course, the market is likely to price in a lower path because of the asymmetry of the Fed’s reaction function: a negative demand shock could be met by sharp rate cuts (back to zero), while the Fed will likely be slow to react to further negative supply shocks, arguing they are temporary. In the medium term, we expect the Fed to learn from its mistakes and raise rates sufficiently to prevent a prolonged and serious inflation outbreak.
This implies we want to keep a negative duration bias, but with positioning still short, we don’t think it’s sensible to be holding short tactical views during periods in which there is no catalyst for repricing.
Clash between currency titans
In currency markets, the US dollar and the euro are the titans. Movements in their exchange rate are important, as the euro and dollar are the centres of gravity for the euro-bloc and dollar-bloc currencies.
The US dollar has been strengthening across the board in 2021 (the DXY dollar index is up 6.6%), with many market observers expecting further appreciation. With US inflation on the rise, rate hikes by the Fed are likely to be brought forward into 2022. That’s reflected in the short end of the interest rate curve, while in the long end, the gap with the Eurozone is widening too. Purely looking at nominal rates, US dollar strength seems obvious.
Today, not many investors are worried about a lack of inflation anywhere – not even in the Eurozone – so without much inflation, differentiation between nominal rates is in the driving seat. Over shorter time periods, we agree that nominal rates are a better predictor for currencies than real rates, at least for developed currencies, but over longer time periods this is not true and real rates form the better anchor.
With expectations for rate hikes by the Fed brought forward, while rate hikes by the European Central Bank remain much more conservatively priced, we believe the bar for surprises has been lowered. This will make it harder for nominal rates to continue pushing the US dollar stronger, while it gives more confidence that currencies cannot de-anchor from real rate moves much longer.
Given this outlook, recent euro weakness appears overdone, in our view. We’re turning more positive on the euro versus the US dollar and are ideally looking for negative sentiment and positioning as a potential opportunity.
We’re not there yet, but as the pandemic rears its ugly head again in Europe with the Austrian lockdown, it may not take long. A period of speculation about who is next feels inevitable. Given how unpredictable COVID-19’s trajectory has been, we have no idea where a new round of lockdowns might end, but rates and currency markets have proven to be quite sensitive to coronavirus waves over the last 12 months.
There is a light election calendar in emerging markets for 2022, with fewer pivotal votes than we will see the year after. There are general elections in Hungary and Poland early next year, followed by a presidential election in South Korea, and then general and presidential elections in the Philippines, Colombia and Brazil.
Will we see an end to Orban’s rule in Hungary? Despite a competitive opposition candidate putting Fidesz on the back foot, an Orban victory remains the base case. In Poland, the Law and Justice party might try to rebuild its majority with a snap election. The outcome depends on the opposition uniting. The task is hard, but not impossible. This matters more broadly as the current government’s spat with the EU is getting more serious.
In South Korea we could see a conservative turn in politics that would result in closer relations with the US and Japan against China, and could lead to a greater risk of miscalculation with North Korea or China. The geopolitical consequences will be the most significant for markets. A generationally divided electorate in South Korea could signal instability and political turbulence in the years ahead.
In the Philippines, the election will be a test for dynastic political machines and the winning president will get substantial powers. This is important for the relationship with China and the US in the Pacific, but we only see limited market impact as most candidates favour broad policy continuity. In Colombia, fiscal constraints are starting to bite, so if the new president is uninterested in fiscal discipline or economic reform, markets are likely to panic.
In Brazil, the current right-wing president Bolsonaro is under strain, increasing the likelihood of a turn to the left with the return of former president Lula. Either way, the constitutionally enforced spending gap, the country’s only fiscal anchor, is under threat. That’s keeping financial markets on their toes. Another key threat comes from the potential inflating away of outstanding public sector debt. Volatility is likely to be high in the runup to the election, and potentially afterwards if institutions are tested. This will be reflected principally in the real, in our view, but also in domestic bond yields and equities.
Please check in again with us soon for further relevant content and market updates as we approach the final month of 2021.