Fidelity’s Global CIOs across asset classes and Salman Ahmed, Global Head of Macro & SAA, debate the outlook for financial markets as we enter the final quarter of 2021. They highlight the key factors we are watching, with a focus on inflation, central bank policy moves and the evolving regulatory environment in China.
The ideas and conclusions here do not necessarily reflect the views of Fidelity’s portfolio managers and are for general interest only. The value of investments can go down as well as up, so your clients may not get back what they invest.
Salman Ahmed (SA): Recent economic data shows that we are well past peak growth. This is a very different situation from the start of the year when growth was positive and accelerating towards peak momentum. The effect on 2022 growth forecasts has so far been muted, but 2023 forecasts have started to come under downward pressure.
Globally, we are now entering a stage where monetary policy is becoming more sensitive to inflation dynamics. The Fed had taken the stance that inflation is transitory, but we've seen a hawkish shift in the dot plots recently as inflation has proved more persistent (with 2022 becoming the battleground for the next hikes rather than 2023). The Bank of England has also become more hawkish than other central banks, setting the scene for a potential hiking cycle.
On the fiscal side, there have also been a lot of developments. In the US, there is a very partisan political situation over the debt ceiling, with the Treasury due to run out of funds somewhere around the middle of October; there will need to be resolution well before that. Our base case is that we will get some sort of resolution as we have in the past, but we have to acknowledge that the situation right now is quite fractured and we have a variety of other fiscal bills on the table, including the infrastructure bill. Some compromises will be needed.
Elsewhere, we are watching an increase in input costs very closely as shortages of key energy items can cause industrial recessions, especially in the winter. In turn, this could slow down inventory rebuild, which has been a key plank of the deflationary environment of recent years. The reality is if carbon prices go up, this will manifest in key commodity prices and the critical question of who pays for it will come on the table.
SA: For several months, we have been in the camp that inflation is likely to be more persistent than what central banks are forecasting. Inflation is clearly on an upward trend and this is consistent across geographies.
The critical question for us is the persistence, the stickiness of this inflation - whether inflation will become a self-fulfilling cycle, which is a situation we haven’t witnessed over the past 20 years. If households and the corporate sector starts to expect inflation, then their decision making will ensure that it comes through. Wages and consumer price inflation will rise as costs are passed over and the real cost of living goes up. We are starting to see signs of this in the UK for sure. We are worried by the prospect of a more self-fulfilling inflationary cycle due to changing expectations of different economic agents in the household and corporate sectors.
We are looking at inflationary regimes very closely and our current view is that real rates are likely to remain negative because of high global debt burdens. When we look at the performance of different asset classes under different regimes, the regime we are most concerned about is rising inflation with low real rates - historically that hasn't been very good for equities or bonds. There are some indications that we are entering such a regime, but whether this is a permanent situation or just a mid-cycle wobble remains to be seen.
Andrew McCaffery (AM): This is one that could go down to the last moment. What happened in 2011 is that we had a very drawn out and difficult process, which led to markets getting nervous. As we get closer to the deadline, the risk of a technical default increases and the implications are that some government departments will be closed down to save money. I think this issue will roll on due to the political challenges we are seeing. In turn, markets are likely to take more notice. If there is an agreement, there will also be distinct repercussions for government activity and markets.
Steve Ellis (SE): Once we get beyond the debt ceiling, the main thing is that we're going to see quite a considerable rebuild of the Treasury general account. There has been a huge amount of liquidity supplied since the start of the pandemic - that is pure, unadulterated quantitative easing that has gone straight into the system and boosted risk assets.
However, when we get beyond the debt ceiling that's going to go into reverse and the US will start rebuilding the Treasury general account (likely by about US$800 billion). As a result, there is likely to be a large drainage of dollar liquidity from the system as we go into the fourth quarter.
AM: If policymakers leave the debt ceiling too late, markets will become more concerned by what a technical default means. Fiscal liquidity drain could also come through as quantitative easing is being reduced; we are yet to see whether the Fed would offset a potential fiscal cliff with stimulus, but if the fiscal cliff occurs as monetary policy is tightening that could present a troublesome situation for the economy and markets. We’re inclined to think that they will give the inflation side more scope and they will look at growth and not want to be too aggressive on tightening.
Romain Boscher (RB): It's clearly a tipping point for equities, because we are moving closer to the end of a very short cycle (I'm tempted to describe it as a reopening cycle, characterised by huge fiscal and monetary stimulus). We are reaching a plateau where momentum on earnings is less favourable and it is important to remember that earnings are key for equities.
We could enter a zone of turbulence, but that doesn't necessarily mean a bear market. We are more cautious, but earnings are still growing so equities could continue their ascent, albeit at a much slower pace and probably with higher volatility. It is time to move away from high risk towards quality.
SA: We recently published a detailed note on China’s three mountains (education, property, healthcare) and the motivations behind China’s recent profound policy shift. Overall, it is about creating a new common prosperity framework - not new in terms of content, but intent to implement. There are issues with the rebalancing of the Chinese economy and large inequality has become more evident within the country (as well as data security issues). China can address the very strong inequality situation it finds itself in as a result of its strong growth in recent years.
SE: Many people think that Evergrande is a Lehman moment, but we certainly don't think that's the case. It is more of a signal that has removed the implicit government guarantee that state-owned enterprises will be bailed out if things go wrong. As those guarantees are now gone, there has been a re-evaluation of risk premium in Chinese credit markets.
The whole property sector is coming under pressure and therefore there's going to be a negative impact on growth. As a result, we have concerns over China’s deleveraging policy and net credit impulse, which are very bad for growth. Although the systemic risk is not apparent, it points to a downward drop in Chinese growth.
AM: The context is that China is looking to create a more resilient economy - there is an acceptance that lower growth is necessary to reposition the economy. From that perspective, this is not by any means a reason to step away from China allocations; the country is still growing more quickly than many others and China will still become the largest economy in the world eventually.
Another aspect is that we've seen significant discounting of growth and regulatory risks in Chinese asset markets already and although the reality is that sentiment will remain challenging, the longer-term risk-reward profile has actually become quite attractive, particularly if we are heading towards a more resilient economy driven by domestic consumption. Therefore, China remains a key part of our global asset allocation thinking, even if it's going to be very choppy waters in the near term.
AMcC: The move towards net zero will absolutely continue, but I do feel that there will be challenges with E, S and G. We’ve spent many years on governance and progress has been achieved, as well as on environmental issues like climate change and biodiversity. However, the past 18 months have really been characterised by the realisation of what is needed in terms of policy in the future - these issues are not going away.
Discussion will continue around climate change policy frameworks and net zero as we approach COP 26; this has the potential to have material impacts on many markets, particularly with state involvement rising as a consequence of Covid-19. Investors that do not incorporate these considerations into their asset allocation and investment selection processes will not be managing risk effectively. However, companies that make the right decisions on sustainability will become more resilient, as will communities and countries.
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This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Investments in emerging markets may be more volatile than other more developed markets. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.