Inflation and China Failed to Rattle Markets. 2022 Might Be Different.

(Bloomberg Opinion) -- A year ago, most economists expected that the Covid-19 pandemic would continue to weigh heavily on the global marketplace, and that the recovery process would be far from smooth. But two changes to the landscape — rapid inflation, and questions about the viability of investing in China — caught nearly everyone off-guard.

Even if we had foreseen these developments, it is unlikely that we would have gotten right their broader implications. And we probably wouldn't have guessed that markets would by and large take the news in stride. That bears remembering as we attempt to make projections for the coming year while still dogged by the pandemic and other uncertainties.

The Inflation Surprise

I know of no forecaster who came close to projecting a nearly 7% U.S. inflation rate for the end of this year, and that includes those of us who pushed back as early as six months ago against the notion that this bout of inflation would prove to be transitory during 2021.

Today, unusually high and persistent inflation has become the consensus call. Yet even now, there is an under-appreciation of the current inflation dynamics, including supply-chain disruptions and worker shortages associated with the new Covid variant, omicron.

The surge in inflation is even more striking given that, unlike what textbooks and prior experience would suggest, its impact on markets has been muted.

Yields on government bonds, for example, have been relatively subdued, with 10-year U.S. Treasury notes still trading around 1.50%. Indeed, if anything, yields adjusted for inflation have fallen deeper into negative territory. Meanwhile, stocks have gone from one record high to another, reaching a total of 70 for the S&P 500 Index this year.

This makes the new year an uncertain proposition for the economy, for markets and for public policy.

Will inflation derail economic growth while also worsening inequality? How long will it take for the Federal Reserve to catch up to inflation realities, and which policy measures will it deploy?

How quickly will a tightening of market financial conditions follow the pivot to fewer stimulus policies from central banks? How big will the economic and financial impact be, in the U.S. and across the world?

Will yields rise as bond investors look to limit the erosion in the real value of their investment? If so, how will stocks react?

Which countries and sectors are particularly sensitive to higher market volatility?

What makes this even more interesting is that it comes with significant political and institutional stakes. From the ability of Democrats to retain control of Congress to the damaged credibility of the Federal Reserve, the 2021 inflation surprise will reverberate throughout 2022.

The China Investability Surprise

A year ago, many (not me) were advocating that investors make a significant portfolio shift from the U.S. to emerging markets, with a heavy emphasis on China. After all, foreign stocks had again lagged behind their U.S. counterparts, adding to the apparent relative valuation advantage with which they had started the year. Meanwhile, China's attractiveness to investors had increased. The country's economy became the first to recover from the pandemic, adding to the promise of a continuation of an impressive multi-decade rise.

Yet to the surprise of many, emerging market equities have underperformed once again. Even more unexpectedly, Chinese stocks have been hit hard this year as, in a move that surprised many investors, the government began reining in private enterprise in tech, real estate and other industries.

As Beijing tightened its grip, conventional assessments of economic and business fundamentals had to take a back seat to political debates about the intensity of the Chinese government's crackdown in the name of “common prosperity.”

This is taking place even as China's zero-Covid policy is challenged by rising infection numbers. The inclination toward a different treatment of domestic and foreign investors further complicates the investment outlook for the world's second most powerful economy.

At the most basic level, it isn't yet clear whether more intervention by Beijing is in the cards or whether the recent default by real estate developer Evergrande will open the way for profitable investing, much as the Russian government's seizure of oil giant Yukos nearly two decades ago ultimately marked a turning point for investors in that country.

Amplifying the surprise around China's investment climate is the lack of any meaningful spread to other emerging markets. What occurred in China has remained in China; and what occurred there was far from the “Lehman moment” that some predicted at midyear.

It is particularly noteworthy that, at least so far, there has been no significant retreat of foreign capital from emerging markets as a whole. Instead, large investors have remained exposed to emerging markets, pushed there in search of higher returns by the low yields and high equity valuations in their home markets in advanced countries.

The evolution of inflation and China's investability constituted big surprises in 2021, as did their lack of spillover into other areas. It remains to be seen how benign last year's surprises will stay for the global economy and markets.

More From Other Writers at Bloomberg Opinion:

The New War on Inflation: Daniel Moss
What Inflation in 2022 Will Teach Us About Capitalism: John Authers
China's Dangerous Rush to Resolve the Property Crisis: Shuli Ren

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens' College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."