Monday digest

Posted 13 December 2021

Overview: Plan B or not Plan B? That is the question
Equity markets began last week in buoyant fashion. The catalyst was a more upbeat reading of the coronavirus narrative that suggested the new variant may be as contagious as the original, but much less damaging, and with the added benefit of conferring some immunity. This viewpoint held sway only briefly. When Prime Minister Boris Johnson, who can’t have had many worse weeks during his premiership, announced ‘Plan B’ restrictions, it became clear the government can ill afford to take the risk of not taking Omicron seriously. However, restrictions over the past two years have been accompanied by support for those directly damaged by the imposition. There was no such help announced this time. In the government’s defence, we are still awaiting scientific conclusions of the risks caused by the Omicron variant, and arguably the outcome will have to come from real world data, meaning observing the consequences of the spreading virus. One may also argue that some of the preventative measures bring the UK more in line with other countries, even if this does not guarantee those measures are the right ones.

However, the longer the health risks posed by city life persist, the more apparent will become a crucial variable in economic activity: rents. Landlords have huge vacancy rates now and there’s almost no opportunist prepared to bet on a return of the office worker. Unfortunately, because landlords are always reluctant to lose the revenue and are not happy to agree lower ongoing rents for current tenants, the market won’t clear quickly, with downside risks lingering. At the onset of the COVID crisis, we (along with many others) mulled over the structural shifts the virus may accelerate. Relaunching IT investment (which has already occurred in many economies) was one of them, but now we are accustomed to altering working practices and therefore cityscapes. Indeed, we can observe a current pattern of the 9-5 office becoming less relevant. Transition phases tend to create winners and losers. Currently, the losers appear to be getting little support. However, it will be crucial that the transitional process is managed by public authorities, not just by an ad-hoc reaction to (by nature) random virus mutations. 

China’s policymakers prepare themselves for action
China had altogether different concerns last week. As the country still runs a zero-COVID policy, Omicron has had very little impact. Consequently, attention is fixed on the domestic economy, and the woes of its property sector. More news of the winding down of floundering property giant Evergrande was counterbalanced by authorities signalling supporting  the rest of the economy. Such backing is crucial to stem contagion into other sectors, even if it is likely that more fiscal support will be needed. Last week, Evergrande missed a US dollar-denominated interest payment, while the shares of smaller rival Kaisa Group Holdings were suspended after it failed to meet its deadline for a loan repayment. At the same time, the media reported Evergrande restructuring plans were taking shape.

Offshore debt and bonds are all set to be included in the restructuring, although questions persist over the treatment of domestic liabilities. It remains to be seen whether domestic bondholders receive their payments, and what will happen for many thousands of people who put down payments on yet-to-be-deposit creditors. On the face of it, the restructuring of a company in default sounds like bad news. However, markets have had low expectations for a good outcome for Evergrande for a long time – at some point, the unavoidable – a restructuring process – had to occur. It could be, however, that the pain is borne more by overseas bond investors. Most investors will be content if there is no further contagion to healthy companies in the sector, or to the broader economy.

In that respect, it’s comforting Chinese US dollar high yield bond spreads fell back last week, rather than rewidening beyond previous levels. Importantly, there is political acknowledgement that support must be forthcoming. The People’s Bank of China lowered its reserves requirements for banks, freeing up an estimated CNY 1.2 trillion ($188 billion) of cash now available for loans. The tone of the Politburo has also turned more accommodative for economic support next year. Quite often, once an ‘orderly’ restructuring process starts, the low point in markets has been reached, even if economic consequences persist.

All eyes on the Fed (again)
In the US, the Federal Open Markets Committee meets next Wednesday, 15 December. Virtually everyone (including us) assumes bond purchases will be tapered more rapidly than the schedule announced in November. The end date for new purchases will most likely be in March. This then brings the expectation for short-term interest rates to then be raised, from 0% to 1% by the end of 2022 (currently the expectation is for a rise to 0.5%). The US Treasury will be the major borrower in the coming months, having put its schedule on hold as it waited for the cessation of ‘debt ceiling’ arguments from both sides of the US Senate. Last Thursday, the Senate voted to allow Congress to raise the debt ceiling with a simple majority vote, ensuring government employees will not face being laid off over the holidays.

There’s been much talk about what level of Fed rates is the right equilibrium rate for the US economy. Currently the market thinks it is about 2%, but several commentators have warned it could (or should) be higher. We think they could be missing something. The inflation-linked bond market gives us a view of where real short-term rates will be in the long-term. For over a year, the real short-term rate has been priced between -0.1% and +0.5%, and at 0% for the past three months. During all the talk of tapering, it has hardly moved. The Fed’s goal is to achieve full employment with stable inflation. It has stopped believing it knows precisely what either level is, but it now thinks it undershot both measures in the past. During this time, investors who took absolutely no risk still made money in real terms. We think the Fed now believes that those investors should probably not lose out, but neither should they benefit. A 0% real rate over the long-term would do that. This means the terminal nominal rate will be wherever the inflation rate settles. Therefore, in about five years’ time, we should expect short rates to be between 2% and 2.5%. They may not get there much earlier.

Summary of Tatton’s outlook for 2022
We expect ‘normalisation’ to be the key theme of 2022. For all the disappointments of this year’s stop-start global recovery, no one can doubt that business and consumer sentiment – as well as general ease of living – improved substantially from the depths of the pandemic. The bottom line is that, barring any further catastrophes, improvement should continue next year. We expect spending at the individual and corporate level to grow as movement of goods and people gets closer to pre-pandemic levels. Monetary policy is set to tighten along with the cyclical recovery, as the world’s central bankers have already suggested. However, normalisation and recovery do not necessarily mean smooth sailing. The last few months have been characterised by extreme supply shortages across the world, geopolitical tensions and, most recently, the emergence of a new, more infectious COVID variant. These issues will take some time to filter through – and we expect supply constraints and Omicron-like scares to continue in the earlier parts of 2022.

For capital markets, teething problems could bite. Impressive returns over the last 21 months pushed up equity valuations substantially. Recovery growth has brought them down in the last quarter, and growth is expected to make good on those valuations eventually. Still, optimism is ‘priced in’ for many assets. Bad news could therefore shake market confidence, and with emergency policy support set to wind down, that could create volatility in the coming months. Ultimately, we are still waiting for the self-sustained portion of the recovery – when central policy support gets replaced by business and consumer confidence, and the economy can run on its own steam. Once that happens, it should restart the cyclical rotation in markets – pushing investors away from the COVID superstars (such as big tech) and into those assets and regions most attuned to global growth.

This should benefit equities and commodities, with the latter also helped by the acceleration towards green infrastructure. It is a negative for bond values, which are likely to be weighed down by the withdrawal of monetary support. A resurgence of damaging COVID infections and further restrictions would clearly be bad for any growth prospects. Strangely though, some have suggested that Omicron could turn out to be good news. If the early (and uncertain) reports that the strain is more contagious but less severe turn out to be true, it could mark a natural end to the pandemic. For our central case, the cycle will continue next year, but we remain selective in where we think will benefit.

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