Volatility has risen sharply as global equities slump to 2022 lows, while global bond yields rise on hawkish rhetoric and policy action from central banks, the US Federal Reserve in particular. The UK has played a role, too, amid heightened concerns about debt sustainability and inflation. Even China has intervened in the foreign exchange market.
Poor economic news became good market news early this week after a disappointing ISM survey of US manufacturing raised hopes of a U-turn from the Federal Reserve on monetary tightening. The S&P 500 index rose by 5.7% in just two days; US stocks had fallen by more than 9% in September.
Nevertheless, there’s no getting away from the recent hawkish turn of the Fed and the European Central Bank (ECB).
Since the Federal Open Market Committee (FOMC) delivered a third 75bp rate increase at its September meeting, officials have kept up their talk about the need to raise interest rates to nail inflation.
Fed chair Powell is now warning that rising unemployment could be the price to be paid for bringing down inflation. Underscoring the rationale for Fed’s aggressive anti-inflation stance was the latest data on the core personal consumption expenditures (PCE) index. Core PCE, which excludes the volatile food and energy components, is the Fed’s preferred measure of inflation. It rose by 4.9% on a year-on-year (YoY) basis in August after increasing by 4.7% in August. The Fed is targeting a 2% rate.
Our research team is in no doubt that the Fed is prepared to push the US into recession to beat inflation. The odds of this happening are uncomfortably high. The 2-year US Treasury yield is consolidating at around 4.2%, while the 10-year yield has fallen back to 3.8% after reaching 4% last week (meaning the curve is inverted, typically viewed as a recession signal). The equity market has taken a beating on the back of rising bond yields (see Exhibit 1).
ECB signals further rate rises
The ECB has also turned more aggressive as inflation in the eurozone pushes higher: September’s headline number reached a record high of 10% YoY and core inflation rose to 4.8% YoY (see Exhibit 2).
The recent victory of Italy’s right-wing coalition in the general election has added to investor concerns about policy uncertainty in Italy and the consequences for the eurozone, also driving bond yields up.
After raising its key policy rates by 75bp in September, the ECB signalled that it would raise interest rates further in the next several policy meetings to curb inflation. At her press conference, President Lagarde suggested that the terminal rate could exceed 2% by December 2022 or February 2023.
In Europe, higher energy prices are simultaneously boosting inflation and weakening real demand, raising the risk of stagflation. Although packages are now in place across Europe to cushion the energy price shock, the inflation problem is far too severe, obliging the ECB to respond even at the expense of recession. Policymakers had already been making the case last week for ‘front-loading’ rate rises via a 75bp increase later this month.
UK outlook remains a worry
Although intervention by the Bank of England and the government’s U-turn on its proposal to abolish the 45% tax rate for the wealthy have helped stabilise UK financial markets, the outlook remains troubled for investors.
The estimated GBP 2 billion savings (out of the total GBP 45 billion package) from the U-turn does not change that fact the planned – and unfunded – fiscal stimulus will add to the UK’s multi-decade high twin deficits. The fiscal deficit hit 2.6% of GDP in Q1 2022 and the current account equates to more than 8% of GDP. The debt-to-GDP ratio (at almost 100% of GDP) is 11.8 percentage points above the EU average.
Unfunded fiscal policy stimulus should lead to an even more severe deficit position, raising the spectre of financing difficulties if there is no compensation for foreign investors given the weaker exchange rate and higher interest rates. The market reacted accordingly by mass selling Gilts and sterling.
Finally, geopolitical tensions have also added to market jitters as four pro-Russian areas of Ukraine voted in referendums on whether to join Russia. Western democracies consider these referendums to have no validity and should not form the basis for Russia’s annexation of these regions.
The spillover of global volatility to the renminbi exchange rate prompted the People’s Bank of China (PBoC) to intervene to prevent a disorderly fall of the currency, which has depreciated by about 8% against the US dollar year-to-date.
After last week’s verbal intervention warning speculators not to “bet on a one-sided appreciation or depreciation of the renminbi”, the PBoC raised onshore banks’ risk reserve ratio for foreign exchange (FX) forward trading to 20% from 0%. A higher ratio increases the transaction cost of forward purchases of foreign exchange (mostly US dollars), helping to mitigate renminbi depreciation pressure.
The PBoC warned it would intervene again if market conditions become disorderly. This could include:
- Further raising the risk reserve ratio for FX forward trading
- Cutting the reserve requirement for FX deposits at commercial banks (thus releasing more US dollars)
- More direct FX sales from the PBoC’s reserves
- Window guidance on banks to sell FX
- Using the ‘counter-cyclical factor’ to influence the renminbi-USD cross rate.
Stock markets have had a bad year-to-date in 2022. The S&P 500 is down by about 25% from the start of the year, its worst performance in 20 years. The sell-off is due to the rise in long-term bond yields and the deterioration in prospects for earnings.
Central banks are forced to keep monetary policy restrictive – i.e. yields high – for some time to bring inflation back to their target rates. This monetary stance looks set to continue to squeeze stock market multiples before inflation subsides.
There may be pressure for the equity risk premium to widen as the global economy slows and risk appetite wanes. This could squeeze market multiples further.
In our view, earnings expectations still look too optimistic relative to the risk of an economic slowdown that central banks are engineering. Any downward revision to earnings expectations would thus likely bring further downward pressure on equity prices.
Hold tight for more stock market volatility.