Three Key Thoughts for 2022
What follow are three important themes that I have spent quite some time thinking about over the past several weeks.
Inflation: The Federal Reserve, supposedly the monitor of the US economy, was among the last to recognize that US inflation is not “transitory,” doing so only when repetitions of that term by Chairman Jerome Powell to discuss the price outlook produced derisive laughter in return. How high could inflation rise to, and how long will it last? While partly dependent on how quickly omicron — and any further variations — can be arrested, the Fed and the US Treasury have a major role to play in that decision.
If, in fact, purchases of Treasurys and agency MBS are ended by mid-March as the Chair suggested at his December 15 press conference, we may have seen the highs of inflation. However, Powell has a history of pivoting when markets react adversely to suggestions of monetary tightening, most notably in January 2019. Note, as well, that he expressed concern about markets — not the economy! — at his press conference in explaining why he did not abruptly end bond purchases and hike rates in mid-December.
If markets react adversely in the first several weeks of 2022, Powell could think of new reasons for why he needs to postpone tightening. Fed by the monetary stimulus (no pun intended), inflation could rise much higher than the four-decade high of 6.8% posted in November. Stay tuned.
Further fiscal stimulus seems less of a risk to inflation than it did even a few weeks ago. Staunch opposition from Senator Joe Manchin in an evenly balanced Senate has stymied progress on President Joe Biden’s Build Back Better program, limiting further escalation in government spending.
Bond yields: After surging in the first quarter of 2021, yields on long-dated Treasurys have dropped and stayed low since. Investors have flocked to hold them despite highly negative real yields. Also, compared with the yield on 10-year German bunds — the European equivalent of “risk free” yield — of negative 18 basis points, even the 1.51% positive yield on Treasurys appears hugely attractive to global investors.
Will, and when will, bond yields rise? Concern about easy monetary policy and rising inflation rates has already pushed up European yields — the bund traded at negative 49 bp as recently as August 20. In the case of Treasurys, only firm indications from the Fed that inflation will become the overwhelming factor determining policy after ending bond buys in March can bring yields down along with the breakeven inflation rate.
In a crucial midterm election year, this is highly unlikely. Efforts to keep the monetary tap open will finally be the factor that pushes up bond yields during the first half of 2022.
China: Even if you are not an investor in Chinese companies, developments within the world’s second largest economy should be of enormous consequence. As we move toward October, Xi Jinping will be working toward gaining an unprecedented third term as the country’s supreme leader. Expect three major fallouts as the invisible campaign proceeds.
First, the deterioration in US - China relations that began during the Trump administration has continued, and the current government’s attitudes may even have hardened. While a military threat from either side is too dangerous to contemplate, attention has shifted to bipartisan support in US Congress to taking economic action to “punish” China. This cannot occur either without the US suffering trade and economic wounds itself.
Second, watch for growing tensions in the Taiwan Strait. Increasing claims of Chinese sovereign control over Taiwan during a crucial year could increase nationalist sentiment and improve political support for Xi. Other than making speeches supporting Taiwanese sovereignty, Western political leaders are unlikely to involve themselves in the hostility themselves. However, signs of a major conflict would dampen global market sentiment.
I end with a theme I have hammered on for years with clients — China’s growing corporate debt burden as the emphasis has been on maintaining a rapid pace of economic growth despite a working-age population that has been declining since 2012. The default last month on some of its $300 billion in debt obligations by Evergrande, a giant property developer, was the first explicit manifestation of the impact. Expect more failures to take place.
I do not believe there will be a “Lehman moment” because the Chinese system is better controlled by authorities compared with US officials’ management of the financial crisis in September 2008. The fallout, on the other hand, could be slower Chinese growth as the buildup in bad debt results in reduced credit creation for several years.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
January 2, 2022
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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