The majority of investment strategists are calling for #bonds to perform positively in the new year as the combination of declining #inflation and dwindling growth will prompt central banks to stop tightening and ease financial conditions in the latter part of the year. Such a wide consensus begs to at least consider the contrarian argument; what would it take to disappoint market participants?

The obvious answer is a reprise of inflation. Signs of inflation becoming entrenched or starting to trend higher again, will scare policy makers into further reducing liquidity. Short of some unforeseeable geopolitical black swan, the only “known unknown” that may be able to substantially revive global inflation would be massive fiscal expansion either in the US or #china . While the former is most unlikely because of political gridlock, the latter is perhaps not so implausible.

China’s handling of C19 first with extreme lockdown and then with what is shaping up as a health care crisis is compounding the economic blow already accrued by the deflation of the vital property sector. The results have been serious economic headwinds and key leading indicators are trending negative (see chart). The repercussions in terms of political consensus has been unprecedented street protests a few weeks back. As the economy deteriorates and the pandemic exacts a toll on millions, Beijing may resort to a fiscal stimulus program akin to what we have witnessed in the US in 2020-2021.

The disbursement of funds directly to households would be unprecedented as China was one of the few major countries not to deploy direct transfers during C19. Yet the action may be justified if deemed necessary to deflate broader political dissent. Chinese leaders are avid students of history and understand all too well what happens should they lose the “mandate of heaven”. Added reason for direct transfers “MMT style” would also be the opportunity to escalate the adoption of DCEP, China’s CBDC (“central bank digital currency”), a key strategic priority for Beijing.

If parameterized on US fiscal spending in 2020/21, such a program could amount to $4-5 trillion. Would that be enough to revive global inflation? Possibly as it would translate into additional demand for energy and materials, markets that are already defined by scarce and fractured supply. While there is no sign the Chinese government may even be considering such a program, there is a non-zero probability it may become reality.

A reprise of inflation would spook most investors and translate into more pain for bonds and equities. A radical rethinking of portfolio structure is in order. At times of heightened sovereign instability like the current one, investors need to put politics & geopolitics at the center of their portfolio allocation process.

Disclosure: Hold all assets mentioned. Not investment advice. Do your own research. Twitter:@pietroventani for more timely comments and updates.

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