This environment requires a constant probing and re-probing of core views given the significant risks on the horizon that have the potential to create a sea change in market dynamics. While beta had a great ride in 2020 and 2021, it is much more difficult to simply follow the market when facing a tidal wave of uncertainties and a wide dispersion of potential outcomes.
The first risk, and I think arguably the most important risk, is a global central bank policy mistake. The bond market is clearly indicating that a policy mistake is on the horizon. There has been a dramatic and sudden shift in rhetoric, not only by the Federal Reserve, but by central banks across the globe. Because of that, we have seen the curve flatten quite dramatically, particularly in the US, as the Fed has changed their view and rhetoric, thereby increasing the path to taper and pulling rate hikes sooner and more dramatically.
Indeed, this has created a challenging environment for central banks. We live in an uncertain world where central banks are dealing with inflation being driven by supply chain issues in their current form and having to think about the path going forward. But to be sure, central bank rate hikes are blunt instruments. The bond market is telling us that, yes, rate hikes will quell inflation, but these may also kill growth at the same time.
The second risk is around China. While we are living in a “political economy” environment, we have witnessed China slowing its growth and being caught in a debt trap. The tried-and-true way that China has typically reengineered growth is by adding on debt and cutting rates. However, I think their capacity to do that going forward is much more limited today, given the fact that they have added so much debt to the system that there simply is not enough capacity to do much more.
At the same time, they are up against a demographic problem. Therefore, we see China as a slowing engine of growth without the same kind of impulse into the global economy that we have witnessed in the past. We view China’s natural slowing down as a major risk going forward for the next decade. Additionally, the fact that about 25 per cent to 30 per cent of the Chinese economy is driven by real estate underscores the issues around that segment of the market – Evergrande in particular – and their ability to engineer a soft landing.
The third risk does not come as a surprise – COVID-19 continues to be a risk that is here to stay. It remains a threat from a global growth perspective, as it can create an uneven path in economic recoveries across the globe that largely depends on factors exogenous to the virus itself. COVID-19 clouds the overall macro environment and makes it inherently more challenging to invest.
However, there are opportunities in 2022 as well. Ironically, the unevenness of growth and market activity in the past 12 months has actually created a lot of alpha opportunities. My view is that beta is dead, and alpha will lead the portfolio charge this year. My enthusiasm, even with these risks, stems from the dislocation we are seeing in the market, causing higher dispersion and opportunities for higher alpha.
Gregory Peters is a co-chief investment officer at PGIM Fixed Income.