Since the 10 November release of the latest US consumer price index, bond yields have fallen and equities have risen. The news of more muted inflation added to other welcome developments including plans by the Chinese authorities to relax their strict anti-Covid measures. Could this be the start of the Christmas rally or is it a desperate attempt by the markets to resist central bank’s efforts to tighten monetary policy?
The answer is probably nuanced: Monetary policy tightening will likely continue, but at a slower pace; inflation will slow too, but celebrations are premature.
US inflation has peaked
While reported inflation repeatedly exceeded market expectations in recent months, it now appears to have peaked in the US. The latest producer price index (PPI) data supports this perception. Just like the consumer price index (CPI) numbers, the PPI data printed lower than expected, even for the core components.
The US bond market reaction after the CPI release was striking: -25bp for the 2-year yield, -30bp for the 5-year yield, -28bp for the 10-year yield and -22bp for the 30-year yield – all on one single day (10 November). Since then, official comments have focused on reminding markets that one data point does not make a trend and that key central bank interest rates still need to rise further. Officials have, however, conceded that the pace of rate rises could eventually slow.
US monetary policymakers now appears to focus more on the state of the labour market. Kansas City Federal Reserve (Fed) President Esther George said: “When I am looking at the labour market that is so tight, I don’t know how you continue to bring this level of inflation down without having some real slowing and maybe we even have contraction in the economy to get there”.
In early November, Fed chair Jerome Powell stressed the importance of staying the course on the inflation fight “even as the labour market slowed.” He said: “I would call it [wage growth] flattening out at a level that’s well-above the level that would be consistent over time with 2% inflation…. I also don’t think that we see a wage price spiral, but again once you see it, you’re in trouble”.
We should not forget that the easing in financial conditions due to lower yields across the curve and rising equity valuations is not the market reaction the Fed wants to see when it is raising policy rates. Markets expectations of an imminent policy ‘pivot’, whereby the Fed drops its tightening stance, are as misplaced as the idea of winning a game of arm wrestling with the central bank.
Doves back at the ECB?
Paradoxically, while inflation has continued to accelerate in the eurozone and should continue to do so for a couple of months still, the European Central Bank (ECB) appears ready to tone down its recent hawkish messaging.
Of course, no-one is talking about a halt in the cycle of rising policy rates or, even less so, about cutting rates. However, recent statements have created the impression that once the deposit rate has been raised to a ‘neutral’ 2.00% or 2.25%, which could happen in in December, the ECB might be less determined to move on towards more restrictive monetary policy.
It is true that recession is on Europe’s doorstep, as the European Commission said in its autumn economic forecast: ‘The EU economy has now entered a much more challenging phase’ that will ‘tip the eurozone and most member states into a recession in the last quarter of 2022.’
For now, market expectations for monetary policy do not appear to take into account these recent comments: Markets expect the ECB’s deposit rate to stabilise at 3.00% from next spring onwards. These expectations have already led to a slight inversion of the German yield curve with a spread between 10-year and 2-year yields falling from +20bp at the end of October to -10bp on 15 November.
Conversely, while US policy rates are expected to rise rapidly, a cumulative decline of 100bp has already been priced for 2023. This indicates some investors still expect the Fed to pivot to a rapid rate cut in the face of recession risks. So, should we expect some arm wrestling or is it liar’s poker?
In any case, the configurations of the yield curves is encouraging us to set up positions anticipating a steepening of yield curves and to consider tactical duration moves in our fixed income portfolios when certain thresholds are exceeded.
Better news from China
Hard data confirmed the loss of momentum in the economy in October. Retail sales fell by 0.7% from September and by 0.5% year-on-year as a result of the lockdowns and property sector woes impacting the purchases of housing-related items. This weakness may explain the timing of the announcements on zero-Covid policy easing plans and property market support.
Twenty measures were launched to loosen the Covid containment strategy which has weighed on activity over the last few years. Beijing did not abandon the policy outright. Adjustments had already been made, particularly this summer.
Steps such as shortening quarantine periods for close contacts show that the leadership may now be willing to take greater risks to boost economic activity. Measures will also be taken to speed up vaccination. The variables to watch remain the number of cases, deaths and hospitalisations.
Chinese equities jumped on the news, with the MSCI China index rising by 25% from the end of October (as of 16 November). This shows that investors are keenly awaiting the reopening of the economy. Outside of China, stocks or sectors that could benefit from a reopening outperformed.
Effects on markets and portfolios
Until the end of the year and ahead of monetary policy meetings by the Fed (on 14 December) and the ECB (on 15 December), financial markets will be alert to any signs of changes in the outlook for inflation. Forthcoming macroeconomic data will be scrutinised for clues as to how it will influence the course of monetary policy in the main developed economies.
While the consensus on recession in 2023 is now broad, we can expect investors to start questioning this unanimity early next year, making for jittery markets. While the outlook for China’s zero-Covid strategy now appears clearer, geopolitical concerns in Europe will unfortunately persist.
That leaves us neutral on our equity exposure with a preference for certain geographies. Overall, we are cautious with regard to risk assets.