China’s zero-Covid policy and US inflation fuel market fears
Decisions to be made by President Xi Jinping and Fed chair Jerome Powell over next few months will determine severity of slowdown
To say the first four months of 2022 have been an unpleasant experience for traders and investors would be a gross understatement. The Bloomberg Global Aggregate Bond Index, a broad measure of government and corporate debt, has plunged by 10.1 per cent, bringing its decline since its peak in January 2021 to 14.3 per cent, the sharpest fall in the history of the index.
The rout in bond markets is matched only by the pervasive pessimism over the outlook for growth. In Bank of America’s latest fund manager survey, published on April 12, the percentage of respondents anticipating a stronger economy fell to its lowest level since the creation of the index in 1994.
More worryingly, expectations of stagflation – the toxic combination of high inflation and weak growth – surged to their highest level since the 2008 financial crisis.
While a plethora of risks across the globe are heightening concerns about soaring inflation and slower growth, markets are fixated on two acute threats: the distinct possibility the US Federal Reserve has lost control over inflation and the economic damage wrought by China’s zerotolerance approach to Covid-19.
The decisions that Fed chairman Jerome Powell and President Xi Jinping make in the next several months will determine how severe the slowdown will be and whether the brutal sell-off in sovereign bonds spreads to the closely watched corporate debt market, triggering a more severe financial shock.
The biggest shift in markets this year is the belated recognition that high inflation will last longer than expected. In Bank of America’s survey, 49 per cent of respondents believed inflation was permanent, compared with 43 per cent deeming it to be transitory. As recently as January, 56 per cent of respondents still believed the surge in prices was temporary.
The dramatic shift stems mainly from the Fed’s own change of heart. The US central bank has become more hawkish since last December, so much so it expects to raise its benchmark rate to 2.5 per cent this year. Even after the Fed’s hawkish pivot, investors believe inflation will remain significantly above its 2 per cent target for the next several years. A market gauge of inflation expectations during the next decade has risen to over 3 per cent, its highest in more than 20 years.
This is worrying for two reasons. First, it suggests the more hawkish the Fed becomes, the more worried markets are about the threat posed by inflation, creating a vicious circle. It also suggests investors do not believe the Fed has the stomach to tighten policy so sharply that it precipitates a severe downturn.
While inflation risks stem mainly from uncertainty over the Fed’s resolve, the growth scare is increasingly attributable to the grim realisation that China will not deviate from its “dynamic zero-Covid” policy.
Just as bond markets are signalling that Powell will eventually flinch, equity markets, especially those in China, reflect a grudging recognition Xi has no intention of reversing course.
The zero-Covid strategy has become the overriding determinant of sentiment towards China, accentuated by Beijing’s reluctance to ease monetary and fiscal policy more aggressively in response to the sharp slowdown.
Echoes of the turmoil in 2015 and 2016 are growing louder, partly because of last week’s dramatic decline in the value of the renminbi against the US dollar. A sharper lockdown-induced downturn looks increasingly likely.
Nomura predicts China will grow by as little as 3.9 per cent this year. This seems too bearish. Yet, even if this is the case, the severity of the disruption caused by the zero-Covid policy has made China the main driver of the growth scare.
A prolonged zero-tolerance regime with no exit strategy in sight, combined with a Fed whose ability to rein in inflation is being questioned as much as its assurance that its tightening campaign will not trigger a recession, is a lethal prospect for markets.
The hope is that China is able to contain the virus well enough to avoid further citywide lockdowns and that the Fed can bring inflation down without severely damaging the US economy. The odds of both of these scenarios playing out simultaneously are slim.
The hope is that China is able to contain the virus well enough to avoid further citywide lockdowns