Top of Mind — Contemplating five big questions for 2022
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By: Adam Berger, CFA, Multi-Asset Strategist
This quarter, we ask what if:
- The Fed stays dovish
- Inflation is a bigger deal than expected
- US rates rise significantly
- A bear market arrives in 2022
- China prioritizes regulation over free markets
In this quarter’s Top of Mind, I address a series of “what if” questions clients have been asking recently, on topics including Fed policy, inflation, interest rates, an equity bear market, and China. I consider the likely drivers and implications of each potential outcome and offer ideas on the market impact and portfolio positioning.
1. What if the Fed stays dovish?
While the Fed has signaled that it is likely to begin raising interest rates in 2022 (potentially four times or more), the outlook for rates at the end of 2022 is still below the level of the fed funds rate before the pandemic. Given that we have not seen the first hike yet and markets have already started the year on shaky ground, it’s also quite possible that the Fed’s tone will tilt more dovish as the year progresses.
So what might drive the Fed to stay dovish? It may be as simple as the central bank remaining committed to the idea of average inflation targeting. I think it’s also reasonable to expect that the Fed may be willing to live with some high CPI prints while COVID wanes and the world opens up — an idea that goes hand in hand with the expectation the Fed may have about more workers reentering the labor pool as some of the fiscal support for families winds down. And finally, to the extent that stagflation becomes a risk, the Fed may prioritize fighting the “stag” over the “flation” (recession risk over inflation risk), which would likely keep them in a dovish posture. (See a recent paper on stagflation from my colleague Nick Petrucelli here .)
How could it impact markets and positioning?
If the Fed proves to be even more dovish than the market expects, the US dollar could be vulnerable. On the other hand, gold and emerging markets could both be beneficiaries of a weaker US dollar in this easing mode.
A dovish Fed would typically be good for the bond market, but if the market takes the dovish stance to mean higher inflation further down the line, then there may be some risk. The offset may be the TINA (there is no alternative) argument; there is a meaningful supply of investors for whom bonds, and government bonds in particular, are the primary asset and that’s not likely to change. An easy Fed should be good for stocks, with the risk of a “taper tantrum” removed, but as with bonds, there is a tail risk that the market begins to worry more about inflation if it seems the Fed is too easy.
How likely is it?
For a variety of reasons (e.g., inflation expectations take time to shift; the Fed doesn’t want responsibility for creating a recession; supply-chain issues are likely moving slowly in the right direction), my base case is a continuation of fairly dovish Fed policy. In addition, there has historically been a tendency to overestimate the degree of Fed tightening. For example, we compared the market’s expectation for the fed funds rate at the beginning of each year to the actual rate at the end of the year, and found that the market estimate was too high in seven of the past 10 years.
2. What if inflation is a bigger deal than the market expects?
Figure 1 shows the US breakeven curve, a reasonable gauge of expected inflation. In March 2020, the market was expecting deflation in the near term and, assuming COVID was going to be a long-term challenge to the economy, inflation at 1% or less over 30 years. By the end of 2020, expected inflation was back to a steady-as-she-goes 2%. But by November of 2021, the one-year expectation was approaching 4% and the longer-term expectation was around 2.5% — a big shift in the context of recent history.
FIGURE 1
We’ve already had some high inflation prints, but my focus here is on the longer term and the potential for inflation above 3% on a five-year or even 10-year basis. There are a number of potential drivers, including additional fiscal spending, especially if it comes as economic growth is picking up. There’s an argument that some of the infrastructure spending that’s to come will be deflationary or disinflationary longer term as it increases capacity, but in the next year or two there will be money going into infrastructure improvements without an immediate boost in supply. Other drivers could include...
