As we have discussed regularly in this column, we foresee a significant change in the economic and investment themes in the second half of this year compared to the first half.
During the first half, the theme was “too good to be true”. The global economy was supported by three major tailwinds: rising pent-up demand, government stimulus, and the opening up of the economy as the result of rapid vaccinations, especially in the West.
GDP growth in many countries is trending upward, while higher purchasing managers’ indices, especially in developed countries, point to a manufacturing recovery.
However, in the second half, the landscape will change dramatically as a result of several headwinds. The first is the slowdown in world economic growth, notably in the world’s two biggest economies.
Economic momentum in the US and China is hitting a plateau and starting to decelerate. Key indicators such as job data in the US, fixed-asset investment in China and retail sales in both countries show signs of softening. We expect the slower momentum will continue in the third quarter.
Meanwhile, we are seeing an inflation surprise. US consumer and producer prices and the price deflator of personal consumption expenditure (PCE) are all showing signs of an upside surprise. Apart from the traditional measure of inflation, Americans’ expectation of price increases in the future, measured by surveys of agencies such as the New York Federal Reserve and the University of Michigan, also point to an upsurge of inflation in the range of 4-5% in the next couple of years.
As the economy improves and inflation becomes a concern, we are seeing signals of tighter controls in major economies, including proposed tax increases in the US and the likelihood that the Federal Reserve will start scaling back its massive bond buying stimulus — known as quantitative easing (QE) — and start an interest-rate increase cycle faster than previously expected.
In our view, the main message from the June 16 Fed meeting was quite significant and may shape the economic and investment picture going forward. The Fed has moved up its projected rate-hike timetable to 2023 from 2024 previously, raised its core PCE projection this year from 2.2% to 3.0%, and revised downward its 2022 unemployment rate projection. These moves have several implications.
First, we believe the Fed is more worried about rising inflation risks than it had been saying earlier. Second, we believe the Fed is likely to begin tapering its latest QE programme this year. This could come after a significant improvement in employment after the US$300 weekly unemployment benefit expires in September.
And third, it is possible the Fed may move even faster on interest rates if inflation does not decrease going forward. In any case, a tightening of monetary policy lies ahead.
As a consequence, the US 10-year bond yield has been moving downward significantly. In fact, it has been on downward trend since the end of March, when it peaked at 1.74%. It recently reached a low of 1.45% and is now hovering below 1.5%.
While long-dated yields have decreased, the 2-year yield has risen to 0.25% from 0.14% before the Fed meeting. The rise at the short end and the decline at the long end have narrowed the spread between the two to 1.2% from around 1.6% previously.
We believe a narrower spread reflects grim prospects for the economic and investment picture going forward.
We view the market as believing that the economy is slowing and risks are increasing amid signs of weaker growth, tightening monetary and fiscal policy, and geopolitical problems.
At the end of March, when the 10-year yield recently peaked, President Joe Biden unveiled his $2.25-trillion American Jobs Plan, which calls for massive infrastructure investments to boost US economic productivity. What worries investors is the hefty price tag is to be funded in part by increases in corporate and capital gains taxes.
Looking at geopolitical risk, US-China relations are not improving. A March meeting between the US secretary of state and his Chinese counterpart ended in high drama, while the Biden administration has banned the trading of 59 Chinese companies’ stocks in the US market. China has countered with a new anti-sanctions law that could spell big trouble for foreign businesses.
Meanwhile, Mr Biden appears to have got the G7 and Nato on board in recognising China as a threat to global democracy. All of this reflects the risk of a serious cold war going forward.
We believe various risks will cause market volatility going forward. That includes tapering by the Fed. During earlier periods when the US central bank trimmed its balance sheet — January to September 2010 (after QE1), June to September 2011 (QE2) and March to July 2016 (QE3) — the 10-year bond yield decrease substantially — by more than 1% or 100 basis points. This is because when liquidity starts drying up, all the risk will be easily spotted on investors’ radar.
When QE1 was winding down, the market concern about the US budget deficit and the sovereign credit rating (S&P eventually downgraded US sovereign debt a year later). During the tapering of QE2 and QE3, the market was more concerned about a euro zone fiscal debt crisis and a hard landing in China. The important point is that, although bond yields decreased in all three episodes, stocks stayed in positive territory in the last (QE3) episode, with the S&P 500 gaining around 300 points.
This means that although investors may be increasingly worried about growth prospects, there will still be some opportunities during the coming era of liquidity tapering and tightening. Investors may just have to look harder to find the sectors that are resilient to higher volatility going forward.