As we head into 2022, we’re asking ourselves: What theme will impact markets the most this year? While our list of potential drivers is long, and we have views around a wide set of outcomes, we rely on the evidence, not the narratives that hold sway in financial markets at various points in time. To come to scientifically-correct conclusions, we draw on a large data set and our deep point-in-time analysis to continually monitor inflation dynamics, economic growth, and market sentiment.
Early last year, one of our themes, which we expected to drive capital market returns, was the steepening of the US yield curve and the implications thereof for markets. Higher rates at the backend engendered nervousness among market participants, with the higher cost of capital viewed as a potential bugbear for global equities. Our take has always been that a steeper yield curve is a positive. We explicitly use the shape of the yield curve as an input variable to our systematic decision making; a steeper curve makes us more optimistic about risky assets.
While this assumption generally holds, it is important to determine whether the circumstances contributing to a steeper curve are different this time. Typically, a stable front end of the curve (pointing to easy financial conditions) paired with a rise at the backend of the curve (a signal for more growth and more credit demand) is positive. We observed this in early 2021, and, as a result, we were primarily overweight risk assets like South African equities, SA bonds, the rand, and emerging and developed market equities. This call has paid off for us.
Looking forward to 2022, we now face a very different situation. Firstly, the curve has flattened significantly after reaching its steepest peak in March 2021. Secondly, the flattening occurred for concerning reasons: a higher discount rate at the front end, pointing to a Fed lift-off and potentially tighter financial conditions in 2022.
In the chart below, we show how steep the front-end of the curve has become: it depicts the difference between the US short term lending rate (LIBOR) and the pricing of the US short-term lending rate two years ahead. We can see that in March 2021, the market was expecting no rise in this rate. Now we are seeing significant expectations of rising short-term rates.
So how worried should we be? Again, the answer must be: it depends. Is the Fed really planning an aggressive hiking cycle to reign in higher inflation, tightening financial conditions potentially at the expense of substantial economic growth one hopes for? Or is the FED planning to enter a milder hiking cycle in reaction to being closer to its target of maximum employment, driven by continued labour market strength and a post-Covid-19 economic recovery, which has outpaced expectations? We think it is the latter.
Our analysis suggests unusually easy financial conditions have been the most vital driver for capital market returns in 2021. For 2022, markets will have to rely on a new dynamic: an ongoing positive trend in the global economic recovery. Our economic modelling suggests that this is possible. It is detecting economic surprises on the upside, an ever stronger labour market in the US and global corporate profitability coming in at close to all-time highs. What are the risks to our view? These would be a more aggressive FED combined with a shallower economic recovery. But once again, it will be our point-in-time, data-driven approach that helps us identify and process information in the timeliest fashion, always ensuring that we adapt quickly and remain well-positioned for whatever challenges the future holds.
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