With the US inflation hawks flying, can the Chinese Tiger roar in 2022?

The Federal Reserve hawks are flying? What is our latest view?

With the recent Federal Reserve meeting, it did not surprise us that Fed Chair Powell maintained a hawkish stance in the press conference. There is definitely a need for the Federal Reserve to keep their options open, with headline US CPI inflation at 7% in December. In addition, the US economy is rapidly approaching full employment, with the recent unemployment rate at 4.0% vs 14.7% during the pandemic. Finally, it is also an election issue as the mid-term elections will be held in November this year. The Federal Reserve had been successful before the meeting to raise market expectations to four hikes for this year and following the FOMC meeting, the market has increased its expectation to five hikes.

Our forecasts are for full year above consensus inflation of +4.6% in 2022 and back to trend of +2.1% in 2023. However, the path is important as we expect inflation to peak in Q1 2022 and decline over the year.

In addition, we maintain four rate hikes for 2022 and an additional four rate hikes in 2023. Furthermore, our expectation of quantitative tightening announcement moves up by one month from July 2022 to June 2022.

Our 10-year Treasury yield forecast remains at 2% and the 2-year yield target at 1.5%. Importantly, the Federal Reserve signaled they would not conduct outright asset sales, rather quantitative tightening will be achieved via caps on reinvestments, allowing the balance sheet to decline smoothly predictably. Prior to  the FOMC, the market had feared a more aggressive outright selling of assets by the Federal Reserve.

We must think of tightening as a combination of interest rate hikes and quantitative tightening.

How will inflation evolve in 2022? What are the key indicators to watch?

The level of inflation and the state of the labour market are obviously central to the Fed’s response. Why aren’t we changing our rate rise forecasts at the moment?

(1) Wage Inflation: Employment Cost Index, which tracks employees’ total compensation, will provide further insights into a possible wage-price spiral. The figure jumped in 3Q 2021. The most recent figure of 1.0% mom for the 4Q actually missed estimates of 1.2%. Of course, the year-on-year rate rose at 4.0%.  The key will be the evolution of labour participation rate this year. To what extent will discourage workers to re-enter the labour force?

(2) Supply Chain: ISM Priced paid – About to Improve?  This can lead CPI by six months. The good news is the figure of suppliers deliveries and priced paid for materials fell to their lowest in a year in December. In addition, a number of indicators are falling from peak levels, such as lumber (-25%) and Baltic Dry freight index (-75%). Auto production is also improving. The key will be to examine the impact of Omicron and any new delays to supply chain as well as other bottlenecks.

(3) Medium-term inflation expectations are actually falling! Another comforting factor for the Fed is that the 5-year inflation expectations are falling year-to-date. This reflects the market’s view that the inflation pickup is cyclical in nature and not structural in the medium term.

Read our last month's report - 2022 Global Outlook & Investment Themes: How to Navigate the Normalisation of Policy

(4) Yield Curve Flattening: When could they Blink? This medium term inflation dilemma is reflected in the recent flattening of yield curve. An inversion (when short-term yields become higher than long-term yields) is typically a sign of a recession coming in 12-18 months and or a possible policy error of too aggressive tightening. Currently, the differential between the 10-year yield and the 2-year yield stands at 57bps. In December 2018, it flattened closer to a 30bps differential before the Federal Reserve pivoted. This will be a key reality check to monitor on market expectations. If the flattening accelerates further, the Federal Reserve could get worried about a potential policy error. Ultimately, we expect growth to slow but still be above trend growth in 2022, with a low chance of recession.

(5) Credit Matters – Watch credit indices as the Federal Reserve also paused tightening when the high yield market seized up in late 2018. Despite some spread widening (as we forecasted in 2022), clearly we are not experiencing frozen credit markets at the moment.

(6) US Economic growth – US growth expected to slow but remain healthy in 2022. Currently, the US economic surprise index is falling which could help easing inflation over the course of 2022. Fiscal stimulus will be a drag.

China: Will the Tiger roar in 2022?

The China economy weakened in 2021 due to the property downturn, Covid-19 restrictions affecting consumption growth, and regulatory pressures. The recent Central Economic Work Council and Politburo meetings in December of 2021 have resulted in a focus on economic stability rather than deleveraging. It was stated that fiscal policy will be front loaded, including boosting infrastructure spending. Therefore, any moves by China to boost both fiscal and monetary stimulus are important catalysts to monitor.

In that regard, China had a second reserve rate cut in December as well as cut in policy rates including medium term lending rate and loan prime rate in January. Furthermore, further reserve rate cut and key rates cut are forecasted in the coming quarter. If these conventional policies are not enough, loosening property curbs and boosting issuance of local government debt seems possible.

When could the Property Downturn End?

Property down cycles have ranged from 12 months on average from peak sales to trough sales and 8 months on average of negative year on year sales growth. The peak sales was experienced in February 2021 and the first month with negative sales growth year-on-year was August 2021.

Hence, based off previous cycle averages, the downturn could end in the second quarter of 2022 on these two metrics. Wildcards such as omicron and further shutdowns clearly remain, and these will have to be closely monitored.

While the easing will be incremental and gradual, it could put an end to further downgrades to economic growth in 2022.

Crucially, opportunities will develop for prudent investors in the coming quarters. We have been positioning defensively via China A-shares last year. They outperformed last year, while China small/mid caps (CSI-500) was also up +17% in 2021, leveraged to the common prosperity theme.

Opportunities will develop for broader China equities and selected China bonds for patient investors in 2022, especially as current valuations remain attractive. Policy will finally turn into a catalyst.

Maintain overweight: Non-US to US equities

Non-US equities have outperforming materially year-to-date against the falling US equities (maintain neutral). Their overweighting to technology shares drives this underperformance. We particularly favour Eurozone, Japan and UK, as their valuations are reasonable and those markets have more exposure to value/cyclicals. We remain overweight two of the best performing sectors EU energy +11% and EU banks +11% year-to-date.

Growth and technology stocks are looking hamstrung currently with higher yields, and they typically stabilize only after the first rate hike.

Historical data shows that high-quality stocks can generally play a defensive role in times of market volatility, and volatility is the name of the game for 2022. Dividend stocks portfolio has also typically done well in a rising rate environment. Hence these are suitable for investors who are bullish on future performance but worried about short-term volatility. 

CONCLUSION / STRATEGY

• The Federal Reserve meeting reignited market fears on the pace of rate rises. We maintain our forecasts for four rate rises in 2022 and four in 2023 with Quantitative Tightening announcement in June 2022, one month earlier than previously forecasted. US inflation could be peaking in the first quarter. Watch out for key indictors which are now pointing towards a lower future inflation. Medium term inflation expectations are actually declining.
• China is the only major economy easing policy in 2022. We have been positioning defensively via China A-shares, which outperformed last year. Opportunities will develop for broader China equities and selected China bonds for patient investors in 2022, especially as current valuations remain attractive.
• We continue to favour Non-US, which have outperformed US Equities (maintain neutral) YTD. We like Eurozone, Japan and UK, as their valuations are reasonable and those markets have more exposure to value/cyclicals. Investors should consider increase exposure to Quality and Dividend Yielding stocks with higher expected market volatility. 
• We are negative on US Treasuries as we see yields to move up further with our yield targets for 2-year at 1.50% and 10-year at 2.0%.
• We also see real assets, precious metals and green commodities as good inflation hedges.