Today’s CIO Weekly Perspectives comes from guest contributor Robert Surgent.
“Few things are riskier than consensus,” wrote Erik Knutzen in the very first of this year’s CIO Weekly Perspectives.
“The new year has begun with investors’ and analysts’ views arguably more closely aligned than they have been for years, anticipating benign early-cycle dynamics that favor riskier assets.”
Back at the start of 2021, the consensus trades associated with this macro view were outlined in one strategy note after another: yield-curve steepeners; selling long-dated Treasuries; selling the dollar; buying cyclical and value stocks, small caps and non-U.S. equity markets; selling defensive stocks, growth stocks and U.S. large caps.
Most worked well for three or four months. But then many began to peter out. By June, when the U.S. Federal Reserve started entertaining the possibility of 2023 rate hikes in its “dot plot,” some, such as the yield-curve steepeners, were collapsing.
It’s no surprise to us that so many investors were caught out. After all, the reflationary macro view was largely correct—and earlier rate hikes were to be expected in that scenario. So, what could have caused the disconnect between economic fundamentals and those ill-fated early-2021 consensus trades?
We think understanding that is critical to understand what’s to come in 2022 and beyond.
Real and Terminal Rates: Not Rising but Falling
In our view, that disconnect can be described in three words: real interest rates. At a deeper level, we are talking about the central bank’s terminal neutral rate—the estimated rate that would achieve full employment and full capacity utilization with stable inflation, and would therefore be the highest rate for this cycle.
Coming into 2021, real rates were negative, but the expected terminal rate was 2.5%. Under the reflationary macro consensus, real rates were expected to rise to come in line with that terminal rate. And that would have been one of the strongest forces feeding the early-2021 consensus trades, many of which were short duration, with low or negative sensitivity to rising rates.
Extraordinarily, however, when the Fed raised the prospect of asset-purchase tapering and rate hikes in June, real rates took another leg down, not up. That was partly due to rising inflation expectations, but it was also due to falling nominal rates: Today, the terminal rate, far from rising or even staying at 2.5%, has declined to around 1.6%.
As we discuss in more detail in a forthcoming article, that was the signal for capitulation in many of the early-2021 consensus trades.
Two Very Different Scenarios
The reasons for the decline in real and terminal rates are contested and multifaceted. Some suggestions are structural—an aging population, China’s economic reorientation, or the demand for yield from pension funds and the global savings glut, for example. Others are cyclical—current inflation is a transitory, supply-driven spike, and the next rate-hike cycle will therefore be a short one.
Whatever the reasons, 2021 has taught us that this cycle is sufficiently different from its historical analogs to bring the old investment playbooks into serious question.
Under traditional modeling, with today’s economic background the expected terminal rate would be around 2.0 – 2.5%, as it was at the start of 2021. Assuming long-term growth of 2.0 – 2.5%, that implies flat or positive real rates. But if our new reality is a 1.5% terminal rate with growth of 2.0 – 2.5%, that implies persistent negative real rates to the tune of 50 to 100 basis points. As we have seen in the two halves of this year, the first scenario results in very different asset-class performance than the second scenario.
So, for 2022 and the rest of this cycle, which is it to be?
The Fed’s Fluid Wordplay
We believe that Fed Chair Jerome Powell may have started to answer that question last Tuesday, when he “retired” the central bank’s favored “transitory inflation” terminology, and suggested that tapering might be completed “perhaps a few months sooner.”
Traditional models drawing on historical analogs would expect that hawkish tightening to push real yields up—and set the early-2021 consensus trades back on track. But to assume such an outcome would be to repeat the mistakes of early 2021. If the terminal rate cannot rise from its current level of 1.6%, it’s difficult to see how real rates can rise, either.
That is why we think the response of investors and the economy to the Fed’s tapering could teach us a lot about the likely path of markets through the rest of this cycle. It’s also why we think the Fed’s fluid wordplay is so critical.
Can it complete this enormous volume of tapering without sounding too hawkish, thereby avoiding a violent market selloff or growth slowdown? If so, a faster hiking cycle may be possible, too, with the terminal rate rising and real rates following. Or could policymakers counterproductively spook investors back into longer-duration assets? Could structural forces keep rates depressed regardless of what the Fed does?
Conviction and Humility
We don’t yet have the conviction to answer these questions. But 2021 has given our Multi-Asset Strategies team conviction on a lot of other things.
First, traditional investment playbooks based on historical analogs can be very misleading in this cycle—humility and diversification is in order. Second, we may not be sure just yet about the direction of terminal and real rates, but we do think they are the critical things to be looking at right now. Third, Fed tapering is likely to be the major test of whether those rates can rise significantly.
And finally, we believe 2022 is going to be a very fluid but decisive year for the performance of asset classes, investment styles, sectors, regions and currencies—potentially setting the tone for the rest of the cycle to come.
In Case You Missed It
- China Purchasing Managers’ Index: +0.9 to 50.1 in November
- Eurozone Consumer Price Index: +0.8% to 4.9% year-over-year
- S&P Case-Shiller Home Price Index: November home prices increased 0.8% month-over-month and increased 19.1% year-over-year (NSA); +1.0% month-over-month (SA)
- U.S. Consumer Confidence: -2.1 to 109.5 in November
- ISM Manufacturing Index: +0.3 to 61.1 in November
- U.S. Initial Jobless Claims: +222,000 for the week ending November 27
- U.S. Employment Report: Nonfarm payrolls increased 210,000 and the unemployment rate decreased to 4.2% in November
- ISM Non-Manufacturing Index: +2.4 to 69.1 in November
What to Watch For
- Tuesday, December 07:
- Eurozone 3Q 2021 GDP (Final)
- Japan 3Q 2021 GDP (Final)
- Thursday December 09:
- U.S. Initial Jobless Claims
- Friday, December 10:
- U.S. Consumer Price Index