2022 Fixed Income Preview - From Great Inflation to Great Moderation?

The year 2021 has been quite turbulent for the global economy and financial markets, as periods of mounting fear amid new Covid waves have been followed by periods of hope that the crisis is close to its end. The situation improved somewhat in the middle of the year, as governments across the world were finally able to ramp up their vaccination programs after some hiccups early in the year, and as new promising treatments were discovered. However, the emergence of the new Omicron variant seems to have dashed any hopes that the end of the pandemic is near. Nevertheless, economic activity and consumer demand rebounded this year after the restrictions started to ease, and global GDP growth has surpassed even the most optimistic projections. Unprecedented fiscal and monetary stimulus played an essential role in this. However, this stimulus created problems of its own, as the resulting strong demand, coupled with the persisting supply bottlenecks, contributed to a significant increase in prices, both for real and financial assets. Inflation spiked to levels not seen in years, not only in emerging economies, but in developed markets as well. This surge in prices has raised doubts about the Fed's commitment to its new policy of average inflation targeting, under which it has pledged to tolerate higher inflation as long as the average over the last few years remains close to the target. Since US inflation has continued to run high and the overall economy and the labor market have significantly improved, markets have been worried that the Fed will be forced to begin tightening policy sooner than had been expected.The recent emergence of a new strain of Covid, dubbed Omicron, jolted markets and reignited fears of a new round of restrictions. Although early indications are that Omicron itself is not any more virulent than existing strains, this episode serves as a stark reminder that the risk of Covid-19 is by no means over. If new strains do emerge that are more dangerous - particularly if they are able to evade vaccines - investors would likely flee into risk-free assets, while inflation expectations and interest rates would sink, allowing the Fed to tone down its hawkishness. Although a return to full-fledged lockdowns seems unlikely, even soft restrictions could add to the strain on global supply chains, intensifying the imbalances in supply and demand, exacerbating the persisting shortages and putting upward pressure on inflation.Since the latter scenario looks more likely to us, we still expect the Fed to begin raising rates next year, as inflation remains uncomfortably high. In this scenario, dollar rates would rise, with the dollar strengthening against DM and EM currencies. After this year's impressive global economic recovery, growth will return to more typical levels next year. Tighter monetary policy and a further reduction in fiscal support across the globe will further weigh on growth, though relatively high inflation should continue to provide support for commodity prices. Still, we expect commodities to come down off this year's highs amid tighter monetary policy, easing supply chain issues and slowing economic growth. Geopolitics has been a major driver for Russian assets this year, and this could remain the case next year. Diplomatic relations between Russia and the West have become increasingly strained. Russia and the US have considerably scaled back their diplomatic presence in each other's countries, while Russia has also suspended its diplomatic mission to NATO in retaliation for the expulsion of its diplomats from the organization. However, there is still a window for dialogue between Russia and the West regarding topics such as international security, global terrorism and climate change. In our base case, we expect the geopolitical risk premium in Russian assets to remain at the current level or ease somewhat. Meanwhile, it will be worth keeping an eye on the geopolitical situation in neighboring FSU countries.