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In the letters that Santa Clause is now receiving, one of the most popular gift requests is no doubt this one: the answer to the question “How will central banks react to inflation next year?”. Let’s take a brief look at the parameters that have driven inflation to new highs.

Bottlenecks caused by supply-side shocks, combined with demand-side shocks caused by accumulated disposable income have triggered a spike in prices of durable goods and commodities. And yet, successive lockdowns should normally have resulted in lower prices for services. That didn’t happen.

Indeed, much of the insufficient demand for services is due to shifts in behaviour that cannot be remedied by lowering prices. If someone doesn’t go to the movies or doesn’t take a flight out of fear of catching Covid, lowering prices will not get him back in a cinema or on a plane. Households could even interpret lower prices as a signal of heightened risk, making them even more risk-averse. In technical terms, the elasticity of demand for some services has reversed itself.

This is a big problem for central banks, as price-elasticity of demand has changed, whereas the increase in total inflation is no longer a reliable indicator of stronger aggregate demand. This is why, investors may be fearing a monetary policy error by the central banks – either by tightening too quickly, thus disrupting growth, or by waiting too long and “getting behind the curve”, which would engender second-round effects (e.g., higher wages, higher inflation expectations from households and investors, etc.) and a shift to a more inflationary paradigm.

Investors are still locked in on the assumption of transitory inflation or, rather, the return to secular stagnation. 30-year US bond yields at 1.70% with annual inflation of 6.2% and 5.5% GDP growth in 2021 is a perfect illustration of the financial repression being orchestrated by central banks, as well as of growth that is returning to a potential that is ultimately limited. If this is true, it’s best to continue favouring quality and growth stocks.

Let’s look more closely at the best-case scenario, in which Covid moves from pandemic to endemic in 2022, clearing the path to a normalisation of monetary policies. Central banks would nonetheless have to be flexible in tapering their asset purchases and in timing their rate hikes. For, a too sudden hike would mean a heavier debt burden for governments, which would widen fiscal deficits even further.

If we were to rank all asset classes in descending order of risk, US bond yields would rank first. Here’s our reasoning: in the event that 30-year US Treasury yields rise to 2.50% (from 1.70% currently), i.e., their March 2021 level, and assuming a duration of 22.8, they would return -18% (0.8%*22.8), all other factors being equal.

In such an environment driven by robust growth, it’s better to favour asset classes able to limit the erosion in capital caused by inflation, including listed stocks and private equity.

Meanwhile, the US dollar’s trajectory will flag the future performances of regional assets. If the dollar falls, it’s better to favour Europe and emerging markets. If it continues to rise, the US will once again certainly outperform other markets.

Let me take this opportunity to wish you safe and happy holidays. I look forward to seeing you at the presentation of our investment strategy at the “ODDO BHF Live 2022” event, on 10 January 2022 at 12:45 pm.

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