Asia CIO 2022 Macro Outlook: The Truman Show

With the spike of volatility in markets since the start of the year and the dramatic shift in monetary guidance from the Fed, it may be time to look back at what our Asia CIO wrote in the beginning of 2022 when he was exploring the risks associated with the unsettling, fast policy decorum that supported the quasi unreal global recovery over the last two years:

The New Year saw macroeconomic data, policymakers' stance and potential public health developments sending mixed signals about the possible markets' dynamics over the next few months. In Western economies, still-robust business conditions will have to digest a significant drag from fiscal policies, while reflation will be at work in China and to some extent in Japan. Emerging economies should remain under pressure from possible successive Covid-19 waves, a strong dollar and, for some of them, toppish/declining commodity prices later in the year. Ultimately, the pace and horizon of normalisation of economic conditions and reversing inflationary pressures will remain at the mercy of two things: Omicron and future variants coupled with the resilience of global health systems, which are being supported by vaccination rates and anti-viral therapeutic developments.

The Truman Show: how will global economy fare without policy support?

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Since April 2020, policymakers in most advanced economies have staged their own version of The Truman Show, a virtual world that could have been a pure fantasy notwithstanding the dramatic human toll from the pandemic. Indeed, in this early version of a global economic Metaverse, the full-blown depression that should have normally resulted from the initial pandemic shock, was replaced by a situation where households' balance sheet improved, private consumption increased, jobs (and in some cases wages') growth accelerated and asset prices ballooned.

From here on, the similarities with the 1998 US comedy-drama start mirroring. Unlike Christof, The Truman Show's producer in the movie, policymakers – at least in the US and to a lesser extent in Europe – are the ones willing to end the program today, considering the characters at play (consumers, entrepreneurs and investors) mature enough to understand the necessity to return to the shores of economic “reality". In the movie, Christof is trying to prevent Truman Burbank, the lead character played by Jim Carrey, from leaving the stage, first by triggering a storm while Truman is sailing towards the edge of his world, then by describing a frightening picture behind the scenes. In today's situation, investors – because they do not perceive the same economic reality – may try forcing the Fed not to drop the set, possibly through a storming sell-off in markets.

Hence, two key questions for 2022: How will the global economy absorb the prospect of a significant withdrawal of policy support? How far apart are the perceptions between investors and central banks about the long-term economic “realities" (i.e. growth and inflation regimes and equilibrium level of interest rates) and who is likely to be right?

Global growth normalisation in 2022

At present, the momentum in global economic conditions still appears robust. As expected, activity is logically not as strong as during the first half of 2021 but it has been improving globally since the end of last year's third quarter when the Delta variant-induced global disruptions, as well as other idiosyncratic supply-side shocks in China, hit the hardest. In the US, recent business surveys for both the manufacturing and services sectors have rebounded materially while various proxies for private consumption remained strong. In China, where growth choked and almost stalled during the summer, supply and private investment stabilised/improved somewhat, in spite of the drag of the property market where transactions and new projects continue to contract.

Other economies as diverse as India, Vietnam or Japan who had to face either an early and dramatic Delta-variant spread (India), unexpected supply-side disruptions (Vietnam) or a mix of mild/prolonged social restrictions and supply bottlenecks (Japan) have all demonstrated continuous or more recent yet rapid bounces after the Delta wave receded or when the prospects of re-opening took place. By contrast, European economies, which have gone through the Delta wave with minimal disruptions, have decelerated significantly in the last months of 2021.

In other words, fluctuations in business conditions over the last six months have been mainly echoing the tide from the previous Delta spread, more or less amplified by local public health policies. Impact from endogenous factors (stronger labour markets, higher wages, lower saving rates…) and other exogenous factors (higher energy prices…) as well as policy support drivers have remained relatively unnoticed over the last few months. For the first months of 2022, at least, we might face a more complex overlaps of these different categories of drivers, whose net consolidated impact points toward a risk of growth deceleration.

2022 should indeed mark another milestone in the process of global growth normalisation as the production gap in most advanced economies has been substantially reduced (Europe) or even almost fully-bridged (US).

After surging by more than 6% (annualised) during the first half of 2021, US GDP has probably grown at a pace below 4% over the last 6 months. It should decelerate further in the first half of 2022. The situation might be slightly different for some developed economies (such as Japan) and emerging countries, especially in Asia, lagging in terms of cyclical catch-up and likely to benefit from the launch of the Regional Comprehensive Economic Partnerships on 1 January, the largest free trade agreement in the world. Those economies might enjoy slightly higher GDP growth in the early months of 2022, in the absence of any additional interference from the Omicron variant. China, by contrast, is struggling not to generate a negative output gap, with domestic consumption, property market and fixed assets investments still weakening before recovering partially in the course of the year, under the benefit of higher credit growth.

Impact of Omicron in Asia

For the time being, Omicron's spread in Asia seems very limited and uneven. There has been no new wave experienced in South or South East Asian countries. Vietnam, where Delta-induced cases had bottomed in late October, experienced a brutal spike in daily new cases from mid-November, with a very limited portion linked to the Omicron variant (which is rather worrisome). China's situation is (again) the wild card. Not in the absolute number of positive cases, which remains infinitesimal by international standards, but because the multiplication of sporadic outbreaks combined with the authorities' zero-tolerance towards the virus, regardless of its actual lethality, might propagate a succession of supply-shocks for both China's economy and the global manufacturing chain.

So far, local and limited outbreaks have been more or less contained, at the usual cost of zero Covid-19 policies: Complete shutdown of Xian (capital of Shaanxi province, city of 13 million inhabitants, and place of one of the largest Samsung Electronics memory chip complex); tight mobility restrictions in 20+ districts from other provinces; full closure of flights and roads heading to Beijing from Ningbo (Zhejiang, third largest container port in the world); almost complete blockage of the trucks in-bound traffic at the Vietnam border. Given the high level of virulence of Omicron, in the context of a Chinese population with a rather low level of immunity, the risk of seeing a systematization of those anecdotal experiences at a large scale is rising, and this very unfortunate timing. The combination of the Lunar New Year festivities and the Winter Olympics in Beijing, raises the fear of even tighter and prolonged restrictions, for most of the first quarter.

Should this risk scenario materialise, Omicron would ultimately weigh more on China's growth, pushing up costs for Western importers and retailers than it would suppress demand in Western advanced economies. The perfect storm would be a combination of Omicron and energy markets stressed by exacerbated geopolitical tensions in Eastern Europe. Global CPI that is expected to reverse from nearly 5% at the end of 2021 to close to 3% by mid-2022, before converging further towards 2% by year-end, may then be stuck around 4% for a little while longer. More fundamentally, this asymmetric impact on demand and supply in the West might force the hand of the Fed and convince it to definitively accelerate not only its quantitative tapering, but also the timing and pace of its Fed funds tightening cycle, as signaled during its December meeting.

Our 2022 outlook

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2022 shall be a year of complex overlaps between multiple risk factors. The impact of these factors is extremely difficult to predict, leading to an extremely wide range of possible outcomes. Beyond the usual humility this exercise involves, we suggest unscrambling those centrifugal forces along the following lines that would support our investment recommendations:
 

1. Global growth should remain close or even slightly above long-term potential, in spite of a sharp deceleration relative to 2021's “extraordinary" pace. Equity prices should progress further but returns could be capped by lower earnings expectations and overall weaker risk appetite. Bond yields might rise in the first part of the year before declining again in the second half.

2. With milder and milder cyclical mini-cycles induced by Covid-19 variants, the scope for value/cyclical outperformance should decrease further. Progressively, secular-themed stocks (quality, asset-light and strong growth companies as well as large caps) should prevail over energy, financials, cyclicals and mid/small caps.

3. Domestic economies should follow diverging trajectories, under contrasting macro policies, leading to higher currencies' volatility. In the US, business conditions will have to absorb a very significant fiscal cliff and a rapid monetary tightening, pushing the USD higher initially. In contrast, China and Japan are likely to be the two major economies trying to reflate, with the risk China's policy remains behind the curve in the initial months of the year.

4. The environment may remain difficult for most non-Asian emerging economies, forced to keep monetary conditions tight, at least during the first half of the year. Asian economies might benefit from a cyclical catch-up, potentially amplified by the new regional trade agreement. Provided China stabilises its domestic situation, Asian credit markets should make a comeback.

5. Omicron is a first wild card in this scenario. If it strikes China and its zero Covid-19 policy, it may translate into a new round of global supply bottlenecks, delaying a reversal in global consumer inflation by a few more months. Persistently high energy costs, due to strong weather-related demand during the winter or extreme geopolitical confrontation in Eastern Europe, would entail similar consequences.

6. Potential additional supply-side shocks would make the task from central banks even more complicated. The Fed has some room to tighten but probably less than it communicates. A clash with the markets' perception should not be immediate but might come later in 2022 when growth would decelerate faster.

7. A policy mistake-induced sell-off in risky assets might be brutal but would remain probably short-lived, as the Fed will have to rapidly pause or even reverse its previous policy course. This would open a longer and more sustainable window of equities and credit performance.

8. Finally, we cannot rule out the definitive mutation of Covid-19 into a low-lethality endemic. Such a positive outcome would support a last and spectacular bout of value/cyclical rally and a re-steepening of the yield curves, but it would also translate to an even more aggressive monetary tightening, with the Fed hitting the wall of a very low US equilibrium interest rate quicker.

9. Investors who feel able to bear higher level of volatility over the next few months should stick to secular-themed stocks (sustainability, asset-light business models, high quality brands, large caps…). Others should seek refuge in diversification, including in long-duration bonds, while accumulating cautiously equities from economies likely to reflate and de-correlate in 2022 (China and to some degree Japan) at the expense of the ones tightening their financial conditions (US).