It’s time to start thinking about macro themes beyond the pandemic’s evolution and the eagerly anticipated economic reopening. We’re looking for the next new piece of incremental macro information that could be the next major market catalyst.
China is at risk of rolling over
There’s much debate about the exact timing of when the global economy might reopen, where a semblance of normality might return. It’s an important discussion since most of our livelihoods depend on it; however, as an investment theme, it’s already earned its status as an old narrative. Financial markets are by nature forward looking—risks are priced based on the best available analysis, itself based on the best information available. At this juncture, uncertainty remains high, but here are some of our working assumptions about macro themes that could be the next to shape the markets.
- We see evidence that China’s economic rebound might have hit its peak. This could create headwinds in the commodities space and affect the strength of the recovery in emerging markets.
- The U.S. Federal Reserve (Fed) is on hold amid relative U.S. economic outperformance even as other major central banks are still floating the idea of interest-rate cuts. The divergence between major central banks is likely to be increasingly visible and relevant to investors.
- While we don’t believe in engaging in the collective guessing game of pinpointing the exact moment when herd immunity could be achieved, we do think that the relative speed at which vaccines are being rolled out in different countries will become a relevant factor ahead, particularly in foreign exchange markets.
- In our view, real rates could rise in the coming months—the speed at which it occurs is a risk that bears monitoring.
Back in April 2020, one of our core views was that manufacturing-based economies would massively outperform their services-based counterparts since manufacturing activities were in many ways much less susceptible to social distancing measures. This formed the bedrock of our K-shaped recovery thesis. China, in particular, with its reputation as the world’s factory still somewhat intact, exited the crisis first and was widely expected to outperform. Besides, a rapidly recovering economy meant, in our view, that market-based measures of inflation such as breakevens would rise as supply chain disruptions and a rebound in Asia-based demand would translate into a lift in commodity prices.
Now, however, there’s growing evidence that China’s cyclical boom is peaking.
Here’s the interesting part—it isn’t entirely driven by COVID-19-related disruption or seasonal weakness: China’s credit impulse is rolling over because policymakers have deliberately tightened both monetary and fiscal conditions in order to rein in debt.
This has important implications for risk assets globally because changes in credit conditions in China tend to lead China’s business cycle, industrial commodities demand, global Purchasing Managers’ Indexes (PMIs), and even broad inflation by three to six months. The market, of course, will sniff out a rollover long before the data decisively turns and, at this juncture, we believe it’s one of the most important macro risks that remains unpriced.
If the Chinese credit impulse rollover persists, it’ll represent both a tactical and strategic change in opinion for us and, importantly, imply that the manufacturing-over-services trade has mostly played out.
The recent pause in the already extended U.S. PMI data will likely amplify this concern. Confirmation that China’s recovery has indeed peaked would also likely suggest that expectations of continued emerging markets outperformance should be tempered, and that commodity prices may soften soon (particularly if supply chain disruptions delay the reopening of the economy), which in turn means that inflation expectations could weaken.
The Fed’s on hold while other central banks remain nervous
We're of the view that markets have been overemphasizing the inflation aspect of the Fed's mandate. This is why we’re skeptical that the U.S. central bank will taper its quantitative easing measures soon. Indeed, in our view, the employment side of the mandate will restrain the tapering conversation until at least Q3.
At the most recent FOMC rate decision press conference, Fed Chair Jerome Powell took great pains to talk about his deep concerns about employment, saying relatively little about inflation.¹ In our view, the message from the Fed couldn’t be clearer—where the central bank’s concerned, employment data matters far more than the Consumer Price Index in the coming months.
That said, what’s also clear to us is that the Fed has reached peak stimulus. If the Fed didn’t ease further in January (despite the economy’s weak showing), it’s unlikely to be nudged into action by the next set of incoming data, which will mostly be positive on a go-forward basis. Indeed, relative U.S. economic outperformance will likely become an important Q1 theme as many developed economies struggle, including Canada and Europe.
It’s important to note, however, that while the Fed may be on hold, that doesn’t preclude it from attempting to dampen yields directly or indirectly should it rise too far, too fast. We believe yield curve control remains on the table for the Fed, as is the option to extend the maturity of its current bond purchases should a taper tantrum-type scenario occur. This will likely place a cap on how high yields can run in the next few months.
A simple framework: how the Fed could unwind policy in three steps
|Step 1: unwind emergency programs||Step 2: announce that tapering of bond purchases is being explored||Step 3: hike rates|
|Happening now||Base case expectation: Q3 2021||Base case expectation: 2024|
|Make no mistake, the Fed has already been phasing out the majority of its emergency programs. Most 13(3) emergency lending facilities were phased out at the end of 2020 while the Fed’s one-month term repurchase operations are set to end after February 9.² Now there’s chatter among strategists that the central bank might raise the interest it pays financial institutions on excess reserve as short-term interest rates edged ever closer to zero,² a sign of abundant liquidity in the cash market. While this doesn’t qualify as a traditional policy normalization, it’s no doubt an unwinding.||The market will eventually have to price in a Fed taper at some point in 2021, but we believe the Fed won’t act in Q1 or at least until employment data materially improves in a sustained manner. In our view, the Fed will also want to see inflation expectations firmly anchored at or above 2% before it acts. We can’t see these conditions materializing until Q3. Although we expect rates to rise from a 12-months plus perspective, taper talk is likely on hold for now.||Markets have priced in a 2023 hike which, in our view, is too aggressive given the central bank’s average inflation targeting framework and focus on climate change and inequality—all of which require rates to stay on hold longer than they would have in past cycles. In our base case scenario, the Fed raises rates in late 2024 and not before.|
Source: Manulife Investment Management, as of February 3, 2021.
It’s also worth noting that although the Fed has signaled it’s unlikely to add any additional easing aimed at the real economy, the Bank of England, the European Central Bank, and the Bank of Canada have all made it clear that rate cuts remain on the table. While we don’t expect these central banks to cut rates, we believe that relative monetary policy divergences between the Fed and other major central banks are only going to get wider. The one exception here being the People’s Bank of China, which is in tightening mode.
Taken together, this means that on a global basis, the largest central banks have likely hit peak liquidity. In our view, the respective biases of the various major central banks strengthen our belief that the U.S. dollar (USD) could experience some countertrend rallies in the short term, which tend to be supportive of U.S. equities.
Foreign exchange and vaccination rates
The timing of the great economic reopening is, of course, dependent on how successful we are at containing the pandemic and how quickly the inoculation program can be executed. But in the absence of historical precedence and in its place plenty of information gaps, we don’t think it’s constructive to engage in a collective guessing game. In our view, it seems the bulk of the macro conversation surrounding “when will the U.S. economy reopen” is focused on what is ultimately semantics.
Cumulative COVID-19 vaccination doses administered per 100 people (%)
However, the relative rate at which different economies are progressing with their respective vaccination programs is relevant—several central banks have tied the pace of vaccinations specifically to the path of near-term monetary policy, including the Bank of Canada and the Fed. Put differently, a slower vaccine rollout implies a relatively later economic recovery and easier monetary policy on a relative basis in the near term.
At the very least, it’s likely to influence the foreign exchange market, where economies with a faster vaccination rollout rate may see its currency strengthen (and vice versa) in the coming months. Specifically, we expect this theme to play out in the United States, where vaccination rollout is picking up rapidly. That said, we remain long-term USD bears although, as mentioned earlier, we think the greenback could experience some countertrend rallies in the short term.
Higher real rates are a growing risk
While most of the general macro conversation focuses on nominal U.S. 10-year yields, we’re more concerned with the possibility of real yields rising—a development that could affect several asset classes.
- In the very short term (next one to three months), we expect nominal rates to remain rangebound but are of the view that breakevens (market-based measure of inflation) are at risk of rolling over, thereby pushing real rates higher. This is because breakevens have now, in our view, appropriately priced medium-term inflation in the 2.0% to 2.5% range with limited additional upside. Additionally, if commodity prices weaken, inflation expectations are likely to soften, which would also have the effect of sending real rates higher.
- From a 12-month perspective, real rates can rise in the event that nominal rates nudge higher (hopefully gradually) even as breakevens remain stagnant at around 2.0%. Crucially, it seems to us that real rates are unlikely to decline further from current levels and the risk is asymmetric to the upside.
A rise in real rates is typically associated with a stronger USD and lower gold prices. It’s also usually viewed as a headwind for the equities market and for that reason, we think it’s an area that investors should pay attention to. However, as long as U.S. real rates remain negative and the speed of the upward move is slow, we don’t see it as a reason—on its own—to be underweight equities.
1 “Fed’s Powell More Worried By Cool Economy Than Hot Markets,” Bloomberg, February 28, 2020. 2 “Statement Regarding Repurchase Operations,” Federal Reserve Bank of New York, January 27, 2021.