You can try to kill inflation, but you might kill the economy too

Charlie Jamieson

Jamieson Coote Bonds

Markets have a huge amount to deal with into 2022, with three major policy changes likely across the year. Individually, any one of these three policy changes would be important for the bond market (and by linkage, all asset markets) but collectively they generate material headwinds.

  1. The significant removal of quantitative easing as a collective policy (some smaller programs may continue but the US and Australia will end QE) removing huge amounts of excess liquidity.
  2. Interest rate hikes – following on from RBNZ and the UK, JCB expects Canada then the US Federal Reserve to hike interest rates, with the RBA expected to be a laggard in this process.
  3. A monstrous decline in fiscal spending after extraordinary programs designed to bridge the pandemic.

Insatiable demand still resides for physical goods in economies that are often very service orientated. Lockdowns have driven the demand for physical goods to spike as ‘just in time manufacturing’ has collided with global lockdowns, and now Omicron self-isolations are causing enormous supply disruptions that could take years to fix. The supply side is slowly healing as evidenced by the recent improvements in the US ISM data seeing new orders falling and inventories rising, but this will not fully normalise easily or quickly.

Policy reaction will be required from Central Bankers in the form of normalising a series of policies that were implemented to hold back the gates of hell in March and April 2020. That moment of financial peril is long past, making those settings overly accommodative as the world enters that late stage of the pandemic. Combined with Biden’s fiscal spending that has saturated the US economy in stimulus, resultant inflation pressures will bring Central Bankers to action. However, Central Bankers have made a significant rod for their own backs. 

If they normalise policy too quickly, they risk setting off a volatility wave which can generate a market re-pricing in highly algorithmic markets (as seen in the bond market in 2021). Central Bankers may very well kill inflation by these actions, but they also may kill off the economy in the process in a highly interest rate sensitive world. 

In Australia for instance, some 36% of spending now goes towards servicing debt repayments. Already as we are cresting the new year, the hot property markets of Sydney and Melbourne have slowed considerably in response to higher fixed rate loan availability. 

Watch the video below to hear more.


Transcript

Hi, I'm Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, and this is a review of markets in December 2021. Over the course of December, bond markets generally performed a little, as we saw this big recovery from the selloff of October. To finish the year, and albeit, it's been a pretty ordinary year for fixed income as an asset class, after doing a spectacular job of defending and protecting portfolios through 2020.

Across the month of December, markets had a lot to deal with, with the rise of the Omicron variant of COVID. Thankfully for now, it doesn't look too nasty, although it is very, very contagious. But markets are grappling with what will the political reaction be to this? Will we see further lockdowns? We've already seen some episodes of this in parts of Europe, and can it disrupt the supply chain in the same way that we've seen that vast disruption through the back part of 2020 and into 2021, which has obviously caused a lot of this inflation impulse. Against that, markets are trying to marriage this off with clearly central bankers that are going to be receding with regard to liquidity.

And we think this is a tremendously important point. Individually, any one of these three stories is an important story for bond markets and therefore for other markets. Those three stories are the removal of quantitative easing. Around the world in 2022 broadly, we are going to be ending quantitative easing, although not every jurisdiction will completely end, but we're taking away a lot of liquidity.

Secondly, we will be hiking interest rates following on from New Zealand, the Bank of England, who have already moved. Next off the line we would expect is Canada. Then the Federal Reserve in the United States, the RBA. Will The ECB ever hike? Who could tell? That's another big story.

And then thirdly, the huge removal of fiscal spending, which economies have enjoyed. Now, if you combine those three together, this has the potential to cause vast volatility. And certainly, we may very well be at the mountaintop in terms of asset markets that have enjoyed incredible liquidity, have been very soothed into this place, really since the GFC. And it's really important to note that all of these things are changing and they're changing as a result of these higher inflation numbers that are printing.

Now, we know that there is insatiable demand for physical goods in economies that are very service-orientated, but when we're all locked up, we all want the same things at the same time. And as just-in-time manufacturing meets global lockdown, that just hasn't been possible to deliver. Those supply chains are healing, but we don't think they'll go back to 2019 easily. So we're seeing things like new orders falling in the ISM surveys, inventories building. Those things are encouraging, but we're not all the way there yet, and it is causing some policy reaction from central bankers who are now receding away from policies that were designed to hold back the gates of hell in March and April of 2020.

Clearly, as we are all very well vaccinated and inoculated, a lot of folks have had COVID offshore, omicron hopefully is less severe, the worst of the health crisis is now past us. That doesn't mean that we don't live with some kind of COVID restriction or in a post-COVID world, but these policies are no longer fit for purpose for our go forward and they need to be amended. And I think you're starting to see equity markets looking like they're thinking these things through.

Growth is still expected to be pretty good in 2022, but there are a few little tells. Commodity markets, which have had a great year, are well off their highs. As we said, a lot of these shipping-type costs, if you look at Baltic Dry and these types of things are also coming off. So there's a lot to watch in here. The bond markets broadly are expecting central banks to do something about it earlier than they had otherwise expected, but long bond yields are still very low.

So they're expecting that, yes, you are going to deal with this inflationary issue. Yes, the issue is predominantly from the supply side. There's not much we can do about that until we stop locking down, get back to a more normalised life, but it can curb the demand channel by pushing interest rates higher, and being a little bit more restrictive in those economy and economic settings. That will have an impact on inflation, but will it also have an impact on economic activity?

We know that we are tremendously interest-rate sensitive. We have gorged on these very low interest rates. I think something like 36% of spending now goes on debt servicing. We know we don't need to probably do a huge amount with regard to moving the interest rate lever to change people's consumptive habits. So markets are searching around for this.

What does that mean for growth? You can certainly attempt to kill inflation, but you might kill the economy as well. And so we do think that 2022, with the combination of no QE or little QE or some rate hikes and potentially more than markets may suggest and a massive withdrawal of fiscal spending have a huge impact on the potential for volatility in markets through 2022.

Now, it's really important to think through, and we'll use the US as the obvious example, Build Back Better is completely dead in the water. Obviously it's been torpedoed by the West Virginian Senator. And this is really critical as we come into midterms in 2022 and US politics. The moderate Democrats are now starting to break away from the more hardened left. And there's a bit of infighting, and this thing can collapse in on itself right as the moderates start to care about their own re-election viabilities coming into midterms at the back end of 2022.

What that means with Biden, who obviously has a paper thin ability to pass legislation in the Senate via reconciliation at 50/50, we've talked about that a lot previously, if those moderates start to drift away, then we get to an economic gridlock. And so all of those fiscal programmes, probably which have been resultant in quite heavy inflationary outcomes, recede away. And without that fiscal spending from 2020 and 2021 in the economy, in order to have growth, we need the private sector to step in and pick up the pieces. So without that fiscal impulse, there is a potential, it's more of an H2 story, but something that certainly bodes watching, because as we know, markets can change pretty quickly on a dime.

We've certainly seen that in the bond market over 2021 with some pretty violent re-pricings in these highly algorithmic markets, which are actually relatively fragile at times once big volumes start to go through and the algorithms step away.

So a lot to think about into 2022, I think it's going to be a really challenging year. We do wish you a very happy holiday season and hope you can spend some time with family and friends and get the rest that we're all going to need to deal with all the twists and turns of 2022. And we very look forward to continuing on our macro conversations and providing these services in the defend and protect liquid government bond markets. Thank you very much and happy holidays.

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Chief Investment Officer
Jamieson Coote Bonds

Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...

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