Global Debt Team: Setting the stage for the year ahead

While the macro backdrop has evolved over the past six months, we believe it remains consistent with a global economy that is experiencing above potential growth with easy financial conditions. The primary change during the period has been inflation. 

Against this backdrop, we share our views for the year ahead.

Inflation: a brief interlude, or here to stay?

Initially deemed transitory, inflation is now shaping up to be more persistent. 

That said, the concern for markets is less whether inflation is transitory and more whether the Fed will waver in its framework and tighten policy in response to political or internal pressure. If it does, the impact on US asset prices is likely to be negative. Less so for global asset prices.

We continue to believe inflation will be transitory if the time frame for markets is 12 months. The forces driving it are hard to predict in shorter time periods, as they relate to supply side bottlenecks in a period of global excess demand. The excess demand issue is far more critical to the longer-term inflation story, in our view.

For inflation to be persistent and not transitory, fiscal policy in the US and globally would need to be engaged for longer periods of time and not just the current period. 

Historically, inflation has been a monetary and fiscal phenomenon. In the current environment, it is driven almost entirely by fiscal policy, apart from in a few emerging markets that have reached extraordinarily accommodative levels.   

Globally, over the next few years, we do not believe that fiscal policy will be engaged at the magnitude it has been historically. If anything, it is likely to be a significantly reduced force in creating excess demand. In such an environment, we believe that inflation will be transitory.

Key players: how will developed and emerging markets respond?

The policy rate gap between emerging and developed markets will continue to grow in nominal terms, and we expect that this will translate into a significant gap in real rates in 2022 as inflation comes down in various emerging markets. 

In our view, the rate path in most high yielding markets delivers sufficient excess premia to provide stability.

In addition, we expect China to provide the policy support needed for stability. The slowdown in China in the middle of the year was one of the main reasons for the instability in global growth in the last six months. As China refocused on inclusive growth and favoured redistributive policies, growth slowed down.

While both fiscal and monetary policies are being eased, it is likely that China will refocus on external trade as part of its policy mix. China is running trade surpluses that are close to record levels – something we believe will continue.

What’s waiting in the wings?

There are some broad conditions that, if met, can set the stage for better relative and absolute performance over a three-year investment horizon in the emerging market asset class.

These conditions include:

1. High nominal interest rates in emerging markets, with potentially high real interest rates in the near future
2. US dollar weakness or, at a minimum, stability
3. Stable or higher commodity prices and improving terms of trade
4. Cheap valuations
5. A predictable path for US financial conditions, particularly interest rates
6. Extreme current market bearishness

As we look at these criteria, we imagine that most of them are being met with the greatest uncertainty around US financial conditions.