To say the first four months of 2022 have been an unpleasant experience for traders and investors would be a gross understatement. The Bloomberg Global Aggregate Bond Index – a broad measure of government and corporate debt – has plunged 10.1 per cent, bringing its decline since its peak in January 2021 to 14.3 per cent, the sharpest fall in the history of the index. The rout in bond markets is matched only by the pervasive pessimism over the outlook for growth. In Bank of America’s latest fund manager survey, published on April 12, the percentage of respondents anticipating a stronger economy fell to its lowest level since the creation of the index in 1994. More worryingly, expectations of stagflation – the toxic combination of high inflation and weak growth – surged to their highest level since the 2008 financial crisis. During the past few months, fears of a policy mistake that will cost the global economy dearly have reached fever pitch. While a plethora of risks across the globe are heightening concerns about soaring inflation and slower growth, markets are fixated on two acute threats: the distinct possibility the US Federal Reserve has lost control over inflation and the economic damage wrought by China’s zero-tolerance approach to Covid-19. The decisions that Fed chairman Jerome Powell and President Xi Jinping make in the next several months will determine how severe the slowdown will be and whether the brutal sell-off in sovereign bonds spreads to the closely watched corporate debt market, triggering a more severe financial shock. The biggest shift in markets since the beginning of this year is the belated recognition that high inflation will last longer than expected. In Bank of America’s survey, 49 per cent of respondents believed inflation was permanent, compared with 43 per cent deeming it to be transitory . As recently as January, 56 per cent of respondents still believed the surge in prices was temporary. The dramatic shift stems mainly from the Fed’s own change of heart. The US central bank has become more hawkish since last December, so much so that it expects to raise its benchmark rate to 2.5 per cent over the course of this year. The problem is that even after the Fed’s hawkish pivot, investors believe inflation will remain significantly above its 2 per cent target for the next several years. A market gauge of inflation expectations during the next decade has risen to more than 3 per cent, its highest level in more than 20 years. This is worrying for two reasons. First, it suggests that the more hawkish the Fed becomes, the more worried markets are about the threat posed by inflation, creating a vicious circle. It also suggests investors do not believe the Fed has the stomach to tighten policy so sharply that it precipitates a severe downturn. How can the world avoid another recession? While inflation risks stem mainly from uncertainty over the Fed’s resolve, the growth scare is increasingly attributable to the grim realisation that China will not deviate from its “ dynamic zero-Covid ” policy. Just as bond markets are signalling that Powell will eventually flinch, equity markets – especially in China – reflect a grudging recognition that Xi has no intention of reversing course. The unexpected citywide lockdown of Shanghai, coupled with fears that the nation’s capital could soon suffer the same fate , has taken the zero-Covid regime into a more dangerous phase. Although the surge in inflation is a hot-button issue in the United States, this pales in comparison with the politicisation of China’s zero-tolerance approach to Covid-19. The costs of easing the draconian restrictions are too high in a vast country with patchy vaccine coverage, and in a year in which Xi is focused on securing a third term in office. The zero-Covid strategy has become the overriding determinant of sentiment towards China, accentuated by Beijing’s reluctance to ease monetary and fiscal policy more aggressively in response to the sharp slowdown. Echoes of the turmoil in 2015 and 2016 are growing louder, partly because of last week’s dramatic decline in the value of the yuan versus the US dollar. While the comparison with the earlier crisis is inapt, a sharper lockdown-induced downturn looks increasingly likely. Nomura believes investors are only starting to come to grips with the scale of the slowdown, and it predicts China will grow by as little as 3.9 per cent this year. This seems too bearish. Yet, even if this is the case, the severity of the disruption caused by the zero-Covid policy has made China the main driver of the growth scare. A prolonged zero-tolerance regime with no exit strategy in sight, combined with a Fed whose ability to rein in inflation is being questioned as much as its assurance that its tightening campaign will not trigger a recession, is a lethal prospect for markets. The hope is that China is able to contain the virus well enough to avoid further citywide lockdowns and that the Fed can bring inflation down without severely damaging the US economy. The odds of both of these scenarios playing out simultaneously are slim. Nicholas Spiro is a partner at Lauressa Advisory