Welcome to J.P. Morgan Global Liquidity’s audio commentary. My name is Aidan Shevlin, I am the Head of the International Global Liquidity Fund Management Team, and today I will be discussing China’s economic and interest rate developments during the fourth quarter of 2021 and the outlook for 2022.
Economic growth stabilized, albeit at low levels, in the fourth quarter as proactive government intervention helped assuage fears of further weakness. Concurrently, rigorous testing and targeted lockdowns helped curtailed the recent Covid outbreaks, allowing the authorities to ease social distancing restrictions. In response to calls for additional monetary policy easing, the People’s Bank of China (PBoC) cut key interest rates and committed to supporting the economy, prompting yields to decline across the curve.
Third quarter GDP exhibited a notable deceleration, increasing by a mere 0.2% quarter on quarter due to sluggish production and consumption. Impacted by multiple headwinds, this was the second lowest reading on record, dragging the annual pace down to 4.9% year on year.
Fortunately, from post Covid lows in September, economic data stabilized during the latter part of the year. Exports remained stronger than expected, supporting a recovery in industrial production as manufacturing bottlenecks eased and power shortages diminished. Meanwhile, the government’s sustained focus on deleveraging the property sector to discourage risky activities further restrained fixed asset investment growth, although the magnitude of the decline slowed. And finally, moribund consumer confidence and sporadic Covid outbreaks throughout the quarter continued to negatively impact retail sales.
Headline inflation increased throughout the fourth quarter, jumping to a 15-month high of 2.3% year on year in December as declining pork prices failed to offset rising vegetable and fuel prices. In contrast, after surging to a 26-year high of 13.5% year on year in October, the producer price index moderated to 12.9% year on year, aided by government efforts to tame commodity prices.
[FISCAL & MONETARY POLICY]
Acknowledging the market’s fading growth momentum, the Central Economic and Work Conference in early December, struck a dovish tone, calling for additional fiscal and monetary policy support to stabilize the economy. In response, the government pledged to expedite fiscal expenditure and front-load measures to encourage domestic demand. While they remain focused on key targets including green industries, decarbonization and innovation, the government also appeared to ease restrictions on owner-occupied property and committed to balancing macro policy stability and long term growth.
Following calls by Premier Li Keqiang for a rate cut to support the economy, the PBoC surprised the market by trimming the reserve requirement ratio by 50bps in early December, which released approximately 1.2trillion renminbi in liquidity. Later in the month, the PBoC surprised the market again, by recommending commercial banks to cut the 1-year Loan Prime Rate, China’s de-facto benchmark funding rate, by 5bps to 3.8%. The accelerated rate cuts were intended to lower interest rate expenses for corporate borrowers while re-stimulating loan demand for small and medium sized enterprises. While the size of the rate cuts was small, the timing was significant, confirming the PBoC’s pivot to a dovish monetary policy stance.
Chinese government bond yields declined and the curve flattened during the quarter as weak economic data magnified expectations of PBoC rate cuts. In contrast, short tenor Shibor and repo yields were more variable due to the withdrawal of liquidity by the PBoC in November and December, and year-end effects.
Although less impacted than offshore markets, property developer defaults continued to weigh on credit spreads and investor sentiment. Finally, despite the PBoC’s efforts to depress the renminbi, notably by hiking the foreign currency reserve requirement ratio by 2% to 9% in December, the currency strengthened to a 3-year high versus the USD during the quarter.
By the end of the fourth quarter, economic growth appeared to have stabilized as the authorities took action to ease regulatory, fiscal and monetary constraints. Nevertheless, key risks, including extended property weakness, escalating US-China tensions and further, disruptive Covid induced lockdowns remain a concern. With growth expected to remain weak and consumer confidence muted, additional support will be necessary to boost domestic demand and ensure the economy continues operate within a reasonable range. This implies the PBoC is likely to cut rates again, suggesting short tenor interest rates are likely to decline further.
Thank you all for joining the conversation today. Should you have any questions, please reach out to your J.P. Morgan Asset Management representative.
Happy New Year! My name is Kyongsoo Noh, and I am a portfolio manager on the ultra-short duration team at J.P. Morgan Asset Management. I am pleased to present the 2022 Q1 Guide to the Markets for Global Liquidity investors.
Looking back over 2021, with over 500 million vaccine shots administered to Americans, trillions of fiscal stimulus and quantitative easing, zero interest rate policy, and pent up consumer demand, it is not a surprise that the US economy recovered strongly despite the global pandemic. The downside to the brisk pace of recovery has been elevated inflation and a tightening labor market, both of which have prompted the Federal Reserve to start unwinding easy monetary policy.
Looking forward to 2022, we see the recovery enduring. However, with less fiscal and monetary support to rely upon, the recovery will be at a decelerated pace compared to last year. In this commentary, we will explore:
• The continued recovery in growth (page 18)
• The path of the pandemic (page 19)
• The monetary response and inflation (pages 31, 27, and 35)
We start on p. 18 of the Guide to take a look at the US economy.
• Real GDP growth for last year is expected to finalize in the area of 6%, which was enough to put us over the pre-pandemic level of output (shown by the solid line of the left chart); this will be the highest year over year (YoY) number since 1984. Growth was supported by:
• $2 trillion in fiscal stimulus (which was about 8% of total nominal GDP)
• $1.4 trillion of quantitative easing (QE) by the Federal Reserve (Fed)
• Zero interest rate policy (ZIRP)
• And pent up consumer demand
• For 2022, we anticipate 3.5% growth for the full year, driven by remaining pent up demand and inventory re-stocking. This is higher than the 2% trend, but only a little more than half of last year’s 6%.
• This year’s growth will not have the luxury of the massive fiscal and monetary stimulus of the prior two years; instead, it will rely more upon savings drawdowns and wage gains
• Aggregate excess savings in the US over the pandemic has been $2.4 trillion, which is plenty of fuel for consumption (JPMorgan Securities)
• BLS Employment Cost for Civilian Workers YoY was 3.7% as of 2021Q3 (Bloomberg); it is expected to be higher than that for Q4
We next turn to p. 19 of the Guide, where we have some updated data on the pandemic.
• It is difficult to fathom now given rapidly rising case counts, but we do see Covid-19 having a declining influence on the US economy going forward: to illustrate this, even in this latest virus wave, we have less social and business restrictions now vs. before we had vaccines, and it will be quite some time before we see government stimulus on par with the packages approved in 2020-2021 again.
• The latest strain of the virus in the US is the Omicron variant; preliminary findings point to a more contagious, but milder version of the disease than the Delta variant
• On the left chart, looking at the sharp growth in the case line and the sizable gap between the case and fatality lines in the latest wave, the data so far corroborates higher communicability and lower severity
• This may mark a step towards the pandemic downshifting to an endemic
• That is not to say the virus will have no influence at all; we are seeing a delay in return to the office (RTTO) plans, cancelled flights, CDC guidance against taking cruises, delayed school openings, and increased hospital admissions as a result of Omicron, but as this wave passes, we believe the virus’ overall hold on the broader economy will diminish
• Therefore, we do not believe Omicron will hinder the unwind of easy monetary policy by the Fed; this contrasts Delta, which was at least partially to blame for the delayed timing of the start of taper
… which brings us to p. 31 of the Guide, and our thoughts on the Fed
• Our call, in Global Liquidity, is for taper to conclude on schedule in March and for three hikes to be implemented in May, September and December
• It is not on this page, but high inflation is front and center for the Fed and is the key driver of the start of easy policy unwind; in fact, the latest headline CPI print was 6.8% YoY, Bloomberg
• If hot inflation persists into early 2022, we may even see the first hike pulled into March
• Unlike other risk markets who typically do not cheer on rate increases, money market investors welcome them with open arms and will enjoy increased returns this year for the first time since the pandemic began.
• Net yields on government and prime money market funds generically could be 50-75bps greater by the end of the year than where they are today
• Later we have some thoughts on Fed balance sheet reduction (also known as quantitative tightening or QT), which we see as a growing possibility in the second half of 2022
Before we get to QT, here are some thoughts on inflation itself. For this part of the discussion, we turn to p. 27 of the Guide.
• Headline inflation is running at 6.8% YoY, which is the highest inflation since 1982
• Even if the Fed, through its Flexible Average Inflation Targeting (FAIT) policy, can tolerate a period of elevated inflation, this reading is well above their zone of tolerance, thus the move to finish taper and start hiking in 2022.
• We are not likely to see relief from high inflation in Q1, at least not from year over year base effects
• This is because inflation only ran between 1.4 and 2.6% in Q1 of last year
• Base effects will not kick in until around mid-year or later, which is when inflation started to run at 5% or greater last year
• Eventually, we think that headline CPI will decline by year end to 4% or possibly lower. The drivers will be:
• Base effects (although they will not kick in until H2)
• Supply bottleneck relief coming from inventory buildup and some shift of consumer demand away from goods and into services
• An overall GDP growth rate in 2022 that is only about half of what it was in 2021
• Any further drop in inflation beyond this would require some cooling of the housing sector, which is expected to increase by a high single digit % in 2022; to see a slowing, or at least deceleration, of home prices, we need to see a steeper curve and higher mortgage rates than what are prevailing today
This brings us to some thoughts on the yield curve, shown on p. 35 of the Guide
• It is not on this page, but the forward curve points to a terminal Fed Funds rate of 2% in this hiking cycle, which is only eight 25bp hikes from now; moreover, hikes are front loaded - most of the hikes are priced for 2022 and 2023
• Some of this is influenced by where longer UST yields are trading
• The 10 year UST yield is only about 1.60% today and appears too low in the context of our nominal GDP growth estimate of 7.5% (3.5% real growth + 4% inflation); this low yield could be implying:
(1) the rates market is underappreciating future growth in the face of diminished stimulus and will steepen once outsized growth is actualized
(2) the rates market is prescient of either a recession in the medium term preventing more than eight hikes or an utter collapse in inflation thus lowering the need for hikes
(3) There are non-economic rates buyers artificially depressing rates including insurance and pension investors who are immunizing portfolios after stellar equity gains, foreign central banks managing FX reserves, and the Fed itself with all of its QE purchases
• As we described earlier in this commentary, we believe in above trend, but not outsized GDP growth and certainly not a recession. We also see a reduction but not a collapse of inflation in 2022. Therefore, we lean towards (3)
• If (3) is the explanation, in order to break the rates curve logjam, the Fed may need to shrink its balance sheet to steepen the curve, which in turn will allow a higher terminal rate and hikes beyond 2023 before the curve inverts.
• Timing-wise, we see QT starting as early as 2022H2. To guard against this scenario, liquidity investors may want to consider sticking with money market and ultrashort strategies and hold off on extending duration until the futures market prices in a higher terminal rate or at least wait for some hikes to occur
And now we have our summary:
• We estimate growth in 2022 to be 3.5%, which is only about half of what we saw last year; we won’t have the tailwinds of fiscal and monetary policy, but instead growth will come from savings drawdowns and wage gains
• We anticipate taper to finish in March, and hikes to occur in May, September, and December. If we see very high inflation persist in the early part of the year, the first hike might be pulled into March
• Eventually base effects, a shift of some consumer demand from goods to services, and slower GDP growth should cool headline CPI inflation over the course of the year to 4%, but relief may not come until mid-year on these fronts
• If the curve remains stubbornly flat, the Fed may need to shrink its balance sheet as early as 2022H2 to steepen the long end, which would increase the capacity for hikes.
• Money market and ultrashort strategies, are well positioned to benefit from this environment of monetary policy normalization; the key is managing investment time horizons
• To explore these topics further, please reach out to your J.P. Morgan Asset Management representative. Thank you for listening, and once again Happy New Year!
Hi, I’m Neil Hutchison, lead portfolio manager for our international ultra-short duration portfolios.
The fourth quarter of 2021 was undoubtedly action packed. From global central banks becoming increasingly concerned about stickier inflation projections, to a new, more transmissible strain of COVID-19. Broad markets moved from risk on, to risk off, and back to risk on again as the fear factor surrounding Omicron faded following welcome severity data. One constant theme that developed towards the end of the year was the shift in central bank tone surrounding inflation. With medium term inflation expectations trending higher, central banks have either started laying the foundations for a withdrawal of accommodative policy, like the Federal Reserve (Fed) and the European Central Bank (ECB), or have already moved to tighten monetary conditions, like the Bank of England which raised rates in December. As we look forward into 2022, with hopefully the worst of the pandemic behind us, we expect a future of steeper curves, and higher yield and return possibilities for our Global Liquidity clients – Although cautious still, this is not something we’ve been able to forecast for many years!
It was not just the Omicron variant keeping market participants from enjoying Christmas parties in mid-December. With the Fed meeting on 15th December and both the Bank of England and ECB on 16th December, the markets were unusually active for this time of year. So first up, the Fed, in a hawkish pivot, ultimately opened the door to a faster pace of rate hikes by speeding up the pace of taper (from $15bn per month to $30bn per month from January). Their revised dot plot now shows three hikes in 2022.
Then came the Bank of England’s, Monetary Policy Committee (MPC). After opting not to hike at its November meeting, the decision to actually lift rates one week after the government moved to “Plan B” – that includes the request to work from home if you can – came somewhat as a surprise.
The decision to raise rates to 25bps from 0.1% was almost unanimous, the vote of 8-1 showing less dissention that one would have expected considering most recent speeches. Ultimately, the most recent inflation prints, as well as stronger labour market data, appeared to force the Committee’s hand.
From pricing Negative Interest Rate Policy (NIRP) at the start of the year, to winning the race to be the first major central bank to start tightening, it really has been a whirlwind 12 months for sterling rates investors. Looking into 2022 , forwards curves could see SONIA at around 1.2% by the end of the year. With the MPC itself pointing to only “modest hikes” ahead, it remains to be seen whether terminal rates can move significantly above 1%.
Finally, the ECB rounded off the festive period central bank gorging. Now, the ECB was always going to be the least hawkish of the three, but even President Lagarde’s messaging was less dovish than expected. In summary, it announced the conclusion of its two main pandemic tools: the PEPP (pandemic emergency purchase programme) in March 2022, and the special conditions of TLTRO III (targeted longer-term refinancing operations) in June 2022. To soften the blow from the reduction in PEPP purchases, it announced its “regular” quantitative easing (QE) programme will be stepped up in Q2, doubling the size of purchases from €20bn to €40bn per month, dropping to €30bn in Q3 and back to €20bn by October onwards.
For inflation and inflation expectations, well as expected, these were ramped up significantly with the 2023 forecast moving from 1.5% to 1.8% and the new 2024 estimate also 1.8%. These are a lot closer to the 2% target, but considering the ECB now looks to a symmetric 2% target and forward guidance that needs “inflation reaching 2% well ahead of the end of its projection horizon and durably for the rest of the projection horizon”, it may be some time before the ECB even considers hiking rates. With this said, and looking at forward curves, it’s interesting to note markets are currently pricing 10bps worth of hikes by the ECB by the end of this year. So either the market is getting ahead of itself or the ECB’s own inflation forecasts continue to creep higher, allowing it to join our UK and American peers in tightening policy.
With cash rates in Europe seemingly locked at negative 50bps or lower, any prospects of higher yields will be welcome for our clients. Despite market conditions keeping the ECB relatively hamstrung, we believe the ECB is closer to hiking rates than it has been in many years. The hawks on the Governing Council appear to be growing louder, keeping rate hike expectations front of mind.
In an rate rising environment, fixed income investors should beware of blindly adding duration into their portfolios. It’s critical to monitor breakevens and consider what is already priced with respect to expected future hikes before adding any investment with interest rate risk. Looking at the front end of the curve, or the sweet spot for Global Liquidity, as at the first week of 2022, the UK curve is projecting another three and a half hikes this year, and in Europe we have 10bps priced. Although of course forecasts ware not a reliable indicator of future results, we would class front end pricing as fair and could even present an opportunity for return. As we look further out the curve with the German 10 year at -12bps and UK 10 year at 1.08%, we would suggest there could be a great risk of repricing to higher yields in 10 years and longer, incurring negative returns.
So in conclusion, we have started the year in a risk on fashion: equities remain near the all-time highs , and central banks are either hiking or laying the foundations to start that process. Vaccines appear to work and Omicron could actually end up further fuelling the risk rally if hospitalisation and death data continue to trend in a positive manner. There is a lot to cheer. Saying that, if the past couple of years has taught us anything, it is to expect the unexpected.
The Global Liquidity strategies, ranging from liquidity funds to ultra-short duration portfolios, aim to outperform relatively well in an environment of rising rates and our solutions could help both corporate treasurers as well as term fixed income investors through 2022.