Principal Monthly Viewpoints (February 2022)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q:With US inflation on the rise, what are your predictions for inflation trends?
A:US prices are rising at the fastest rate in nearly 40 years due to sustained and robust consumer demand, unresolved supply chain issues and higher energy costs. However, as energy prices start subsiding and supply chain issues get resolved, US inflation figures may peak in the following months. Considering the high base effect, inflation should return to around 3% by the end of the year, and further retreat to levels above 2% by 2023 year-end.
Looking at energy prices, despite factors like extreme weather and possible short-term disruptions in production may push US crude oil futures to an even higher level in the short run, we believe there is limited room for energy prices to rise in the medium term. Prices of oil and natural gas have completely recovered from the excessive lows in 2020. One such example is US crude oil, which surged nearly 70% in the last year alone. Growth in oil demand is likely to ease as the economy loses steam, while OPEC+ and US producers shall probably maintain or enhance production. Thus, supply and demand may achieve equilibrium again this year. US oil prices may return to the USD 80 level by year-end. A stabilization of energy prices should mitigate global inflation.
Signs of some supply chain restraints getting resolved can be seen now, especially in Southeast Asia. With vaccination rates on the rise, restrictions imposed in response to the pandemic could be lifted, allowing factories and production lines to reopen and this, in turn, could expedite Asia’s economic recovery and ease interruptions in global supply chains. Despite the Omicron variant causing a rebound in the number of confirmed cases, it seemingly has a lesser impact on supply chains than previous variants. In recent months, shipping restrictions also look set to be lifted, with shipping costs of dry bulk, air transport and containers coming down from their highs, which may help alleviate inflation in the second half of the year.
Q:How will this affect the Fed’s monetary policy?
A: Since inflation in the US has remained high, markets believe there is a higher probability of Fed hiking rates more aggressively. The latest interest rate futures show that markets expect the Fed to raise rates five times this year. Against a backdrop of high inflation, tight local labor markets and continued rapid rise in hourly wages, stabilizing prices became the primary objective of the Fed’s policy.
As the bond purchasing program may draw to a close by mid-March, we believe the Fed will commence rate hikes immediately thereafter. In the first half of the year, two to three hikes of 25 bps may be implemented, i.e. rates may be adjusted at each FOMC meeting. However, as issues related to supply chains and high inflation gradually get resolved, rate hikes may become less frequent in the latter half of the year, down to one to two 25bps hikes.
The unwinding of balance sheets, we believe, will start as soon as mid-year or in the third quarter, which means the Fed may initiate steps in this direction while rates are still low, which is earlier than the timing in 2015. The unwinding will move in a predictable manner, mainly through adjustments of reinvested amounts. In other words, the Fed will not actively sell assets for the time being, but bonds that have reached maturity will not be extended, allowing its USD 8.8 trillion balance sheet to wind down. This means reduced support for market liquidity.
Q: Confronted by such uncertainties, how should assets be allocated?
A: After entering 2022, the impending tightening cycle has led to equity corrections. However, sustained and considerable declines in stock prices are usually associated with economic recession. Despite the growth of global and US economies moderating this year, they are likely to expand at a rate above the long-term trends.
Outside of the US, the Bank of England (BoE) may further raise rates twice in the first half, implying that policy rates may hit 1% by May, which may prompt the BoE to sell bonds actively to unwind its balance sheet at a faster pace. Nonetheless, the likely lower inflationary pressure in the second half may cool the pace of rate hikes, and we predict one hike at the most in the latter half and another in 2023.
Compared with its counterparts in the US and UK, the ECB faces the prospects of rising energy prices affecting the economy, lower potential pressure on wages within the Eurozone, and inflation expectations very close to its 2% target. Thus, it may be more patient with rate hikes and kick off the rate hike cycle by the end of the year at the earliest, increasing the benchmark rate to -0.25%. The scale of bond purchases will be further reduced in the following quarters, with a chance of the program ending by the fourth quarter.
With monetary tightening by central banks in developed markets picking up pace this year, market volatility may intensify. Global financial conditions could become even tighter, but are expected to remain accommodative overall. Balance sheets of G4 (the Fed, ECB, BoE and BoJ) currently exceed USD 26 trillion, reflecting abundant market liquidity. Capital may continue to flow towards assets with greater potential returns.
Meanwhile, despite the yield of 10-year US Treasuries rising rapidly, real rates are likely to remain negative, which could support stock market performance. In fact, investment markets usually experience volatility in the lead-up to and initial stages of rate hikes, while upward trends in stock markets remain unaffected. Notwithstanding 17 consecutive rate hikes by the Fed between 2004 and 2006, the S&P 500 still registered annualized total returns of over 10%.
In terms of overall investment allocations, investors should therefore consider maintaining a higher proportion of stocks than bonds. Considering fundamentals such as the economy and policies, we continue to prefer stocks from the developed markets. For bonds, short duration high yield bonds should be considered, while exposure to traditional bonds with a higher correlation to inflation should be cut back. In an environment of low rates and high inflation, alternative assets including infrastructure, commodities such as gold, as well as REITs could be used to diversify portfolio risk. By lowering the correlation with traditional asset classes, more diversified income and greater potential returns could be achieved.
(Written on 7th February 2022)
Crystal Chan
Senior Investment Specialist
Principal Asset Management (Asia)