Financial markets have continued to adjust to less accommodative monetary policies, leaving behind the era of ‘lower for longer’ yields. The ultimate effect on risky assets is difficult to determine at this point as bearings are lost and new ones need to be found.
Data released in the first few weeks of 2022 has painted a murky picture of the economy, reflecting the impact of the virulent Omicron outbreak on activity and mobility in many parts of the world.
Chinese Q4 GDP growth came out at just 4.0% year-on-year, confirming the slowdown seen throughout the second half of 2021. Tighter regulations, real estate sector turmoil and strict lockdowns weighed on activity in December. The trend could continue in early 2022.
There was no bright spark from the latest US retail sales numbers either: December sales were down by 1.9% from the already downwardly revised November figures. Household worries and pandemic restrictions were behind what was the largest drop in sales in 10 months. Anticipatory purchases in October, as consumers worried about shortages, probably contributed to the slowdown in November and December.
Taking a longer perspective, December sales were up by 19% on February 2020 – before the pandemic – and up by 13% on December 2020.
Rising household incomes against a backdrop of solid job creation and rising wages argue for spending to hold up well in the coming months, but higher inflation will dent households’ purchasing power and contain retail sales.
The results of the first of the US regional manufacturing surveys (conducted by the Federal Reserve Bank of New York) showed a sharp deterioration in activity. The Empire State Index plunged by 33 points to slightly below zero as orders fell sharply.
We don’t believe so. From an economic point of view, domestic demand, which has been supported by continuing gains in employment, appears solid enough to reaccelerate once the dust settles. Even though we have revised down our GDP growth forecasts by 0.3 percentage points for the US and 0.2ppt for the eurozone, our medium-term scenario is intact. GDP growth this year should be well above the long-term average for G10 economies.
In China, where the slowdown has deeper causes, the authorities appear to have decided to renew support for the economy. On 17 January, the People’s Bank of China cut its medium-term credit facility rate for the first time since April 2020; this was earlier than expected and also deeper than anticipated. Further policy easing moves look likely to follow.
The effects of the Omicron wave on growth should start to ease. The outbreak has started to fade and it has caused far fewer hospitalisations and deaths than previous variants. Several governments are considering lifting restrictions, which in many cases were less stringent to begin with. Vaccination appears to have become the priority.
Thus there are hopes that this variant marks the first manifestation of an endemic disease. Confirmation would be a boon for markets. Admittedly, the pandemic has already become less of a focus for investors.
Global equities started falling on 5 January when the minutes of the December meeting of US monetary policymakers confirmed the US Federal Reserve’s less dovish stance. Between 4 and 19 January, the MSCI AC World index (in US dollar terms) fell by 4.0% to its lowest point since 20 December.
However, for us, this decline does not have the characteristics of a broad capitulation. It has been quite selective. At the close of 19 January, the S&P 500 index was down by 4.9% from the end of 2021, while the tech-heavy Nasdaq composite dropped by a much larger 9.1% to the lowest level since early October (see Exhibit 1).
The 35bp rise in US 10-year yields hit growth stock indices hard – this market segment is particularly vulnerable to a higher discount rate.
One topic has dominated markets since the beginning of the year: Expectations of the Fed raising policy rates soon and running down its asset-heavy balance sheet in the face of rising inflation.
Clearly, investors believe that the latest – soft – economic data will not divert the Fed and other leading central banks from their post-pandemic tightening roadmap.
The Fed’s policy meeting on 25 and 26 January should allow it to confirm that the first increase in its key rates will occur in March, as anticipated by current fed funds futures levels. It looks likely that the media briefing will be devoted largely to the question of the balance sheet, that is, the unwinding of pandemic-era asset purchases.
We expect markets to refocus on fundamentals. This can already be seen in part in the diverse returns for equities (see above) and credit. As such, the start of the corporate earnings reporting season will be watched particularly closely for clues.
Beyond this, investors will be adapting to changing monetary policies. There is room for normalisation now that the economic environment is favourable. However, change is a source of stress and the road could be bumpy. There will certainly be opportunities for investors, but it is also important that asset allocation choices are made taking into account the risk of a more brutal rise in interest rates.
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