Since both factors will have a profound impact on economic conditions and asset prices next year, investors would be well advised not to overplay tweaks in policy and instead focus on the underlying issues that will determine whether the hoped-for shifts materialise.
No sooner did the government relax quarantine requirements for close contacts and overseas travellers than a surge in the number of daily cases to a near record high forced it to revert to its old playbook of strict curbs on people’s movements and frequent testing, sowing confusion over how it intends to manage the pandemic without enforcing the zero-Covid policy stringently.
Yet, Beijing never signalled that it planned to reopen the economy. Its objective is to try to avoid further Shanghai-style citywide lockdowns. The problem is that the transition from sweeping shutdowns and mass testing to even a partial reopening is fraught with risk.
Rather than reading too much into supposed shifts in policy, investors should instead focus on the efficacy of steps to prepare the ground for a reopening. The most important ones are a change in the political rhetoric around the virus, ramping up the vaccination drive and relieving pressure on the country’s poorly equipped healthcare system by allowing people with asymptomatic and less severe cases to isolate at home.
The acid test of China’s willingness and ability to reopen is whether Beijing’s propaganda machine starts to meaningfully downplay the health risks of contracting the virus for those who are fully vaccinated. Just as importantly, there needs to be a sharp increase in the share of older people – particularly the over-80s – who have been fully inoculated. Based on these two measures, China is not even close to reopening.
Markets have also overreacted to signs the Fed is about to slow the pace of rate increases. A pivot towards less aggressive tightening looks more likely after a fall in America’s inflation rate last month, and the strong likelihood that prices will decline further next year due to sharp falls in commodity prices and an easing in pandemic-related disruptions.
Yet, again, investors are finding it hard to see the wood for the trees. While headline inflation is coming down, underlying inflationary pressures – especially wages which are growing at an annual rate of more than 5 per cent – are far too strong for the Fed to relent. Not only will rates need to rise to a higher level than anticipated, they will need to stay there for a longer period.
It is not the pace of tightening that matters, but how much damage – domestically and globally – is likely to be caused before the Fed is forced to start cutting rates. In a report published on Monday, JPMorgan said: “Catalysts for a proper pivot (cutting rates) are likely some combination of increased unemployment, declining inflation, and something breaking in financial markets.”
This means investors should be careful what they wish for. Not only is a recession likely to be the key factor that brings the Fed’s rate-hiking cycle to an end, it is not even clear whether a sharp downturn will be enough to bring inflation back down to target. In China, meanwhile, even a partial reopening, if badly planned and poorly executed, could result in a devastating outbreak.
For governments and central banks, one of the biggest challenges next year will be managing expectations. For markets, resisting overinterpreting shifts in policy that are misleading is likely to prove even harder.
Nicholas Spiro is a partner at Lauressa Advisory