- Central banks react to inflation, as the market moves to price in several hikes across developed nations
- Companies with negative earnings experience have strong downward pressure on share prices
- With inflation still strong, we have added to our commodity allocation which has helped performance this week
- Outlook: the first Fed meeting of 2022; provisional PMIs and a large number of companies reporting
Central banks react to inflation, as the market moves to price in several hikes across developed nations
Equities and government bonds had a poor week as hawkish rhetoric in broader markets grew stronger, with investors moving to price in a tighter monetary policy that is both sooner and more severe than was only recently expected. It’s becoming clear that this year will be a battle between financial conditions and central banks, with the path of inflation also proving to be a source of uncertainty.
Whilst the Federal Reserve (the Fed) is leading the way with its hawkish pivot, a tightening in monetary policy seems imminent across multiple advanced economies. At the time of writing, markets are pricing in four hikes for the Fed in 2022, over four for the Bank of England, and over six for the Bank of Canada. It’s a slightly different story in Europe, with only 1-2 hikes priced in for the year, with European Central Bank President Lagarde emphasising that the bank has every reason not to act as quickly and abruptly as the Fed, as inflation forecasts are relatively close to, rather than very much ahead of, the bank’s target.
On the other side of the coin, the People’s Bank of China cut the rate on both its one-year medium-term lending facility to banks and its one-year and five-year loan prime rates by between 5-10bp, as concerns about the pace of domestic growth and debt issues within the local property market deepened. This was helpful for our positioning as we increased our exposure to Chinese government bonds during Q4, which we thought would benefit from the relatively more supportive policy backdrop. The market expects further rate cuts from the central bank in the coming months.
Companies with negative earnings see strong downward pressure on share prices
The earnings season in the US got properly underway this week with 43 companies (representing 8% of S&P 500 market cap) reporting. The standout feature has been the sharp downward price reaction to negative surprises, echoing the poor equity market dynamics we've seen so far this year. For example, Goldman Sachs fell -7% after reporting operating costs higher than consensus expected, most notably wage prices which rose 30% year on year. Netflix also posted disappointing subscriber growth on Thursday after the US close, and the sharp fall of -20% in afterhours trading is particularly notable for a stock which has such a large market cap.
Thus far, the share price reaction reminds us that the companies which have done particularly well since the beginning of the pandemic are vulnerable to a correction. Hence, when looking for opportunities amidst the current market volatility, we are focused on those laggard indices which provide a much larger buffer (e.g. emerging market equities).
With inflation still strong, we have added to our commodity allocation which helped performance this week
The annual consumer price index in the UK rose to 5.4% year on year, ahead of market forecasts and up from November’s 5.1% rate. Rising food, petrol and household energy costs drove the headline figure higher. Expectations have grown that headline inflation could hit 7% in April. Meanwhile, core inflation, which excludes energy and food prices, also jumped 4.2% on an annual basis, up from 4.0% in the previous month. The 10-year gilt yield rose above 1.2%, the highest level since February 2019. It was a similar story in Europe, where annual inflation (according to preliminary figures) increased to 5.0% in December, a new high, up from 4.9% in November and just 0.9% in January 2021. Within our strategy, despite the cyclical appeal of commodities having waned, we have added to our already reasonable allocation due to their attraction as a hedge to upside inflation risks, such as those we saw this week.
Outlook: the first Fed meeting of 2022, provisional PMIs and a large number of companies reporting
As recent weeks have seen investors increase their expectations of a faster tightening of monetary policy to curb strong inflation, the Fed meeting on Wednesday subsequent press conference from Chair Jerome Powell will be watched closely. Outside of that, it is an eventful week on the data front with the main highlights being the provisional PMIs which should provide an indication of how the global economy has fared coming into the new year. Lastly, the earnings season really ramps up with a number of US tech companies reporting. In total, a further 106 of the S&P 500 are due to report, along with 46 companies in the Stoxx 600.
- US inflation in-line with expectations at 7.0% (YoY), the highest level since 1982
- Federal Reserve now pricing in four hikes in 2022, rhetoric remains hawkish
- Commodity prices continue to rise, adding to inflationary pressure; UK Omicron cases start to decline
- Outlook: Update on Chinese growth, UK inflation, Bank of Japan meets, Q4 earnings season continues in earnest
US inflation in-line with expectations at 7.0% (YoY), the highest level since 1982
Undoubtably the most eagerly anticipated print of the week was the December US CPI release, which rose 0.5% over the month and an eye-watering 7.0% over the last 12 months. Although widely expected, this is the highest inflationary print since 1982 when the Fed Funds rate was at 13%. However, while the year-on-year numbers were in line with expectations the core and month-on-month figures were modestly firmer than expected by the market. Used cars and trucks continued to provide inflationary impetus, with prices rising +3.5% m-o-m, but perhaps more concerning for policymakers was the above expectation contribution from more “sticky” measures of inflation such as owner equivalent rents at +0.4% month-on-month. Despite the potential impact of Omicron upon the leisure sector, both airfares and lodging away from home posted large increases over the month, of 2.7% and 1.2%, respectively.
However, the market was largely expecting an inflation print of this magnitude, which explains a relatively muted overall reaction. Despite some intra-day volatility on Wednesday, government bond markets ended the week largely unchanged. The Fund’s low duration exposure (versus history) remains appropriate given the risk of higher yields if inflation pressures become more permanent. Equity markets were modestly weaker over the period, with US indices underperforming their peers.
Federal Reserve now pricing in four hikes in 2022, rhetoric remains hawkish
The hawkish tone from the Federal Reserve (Fed) continued, with the Fed funds futures market pricing an c.90% chance of a March hike by the US Federal Reserve and up to three more rate hikes to follow over the course of the year. Speeches by several members of the Federal Open Market Committee reiterated the more hawkish tone from the recent Fed minutes and indeed, from Fed Chair Powell’s renomination hearing before the Senate Banking Committee. Philadelphia Fed President Harker stated that he forecast a “25bp increase in March” followed by two more hikes but that a fourth hike could be warranted “if inflation is not getting under control”. Governor Brainard (as part of her nomination hearing to become Fed Vice-Chair) stated that they would be in a position to hike when asset purchases were terminated, which is currently expected to be in March.
The evolution of the inflationary story in the US and other developed economies remains critical to understanding the likely central bank response and the knock-on impact effect on markets. So far, inflationary pressure is rising alongside a positive backdrop to economic growth; an environment in which a pro-cyclical bias in the Fund’s positioning remains warranted.
Commodity prices continue to rise, adding to inflationary pressure; UK Omicron cases start to decline
Commodity prices continued to rise over the period, especially oil, with Brent crude hitting over $85/bbl. Just six weeks earlier, Brent had been trading just below $69/bbl, as the market was digesting the possible impact of the Omicron variant upon economic activity. Within European markets we also saw a surge in natural gas prices (up nearly 14% on Friday) following the announcement from Russia’s deputy foreign minister, Sergei Ryabkov, that talks between Russia and the US had reached a “dead end”. This is against a backdrop of rising tensions with Russia rejecting any inclusion of the Ukraine into NATO and the US calling for Russian troops to pull back from the Ukrainian border. Although most commodity prices remain below their 2021 highs, this recent rise will limit any normalisation impact of inflation.
A number of developed economies announced record positive one-day case counts, with the US hitting over 1 million daily cases. However, there was some good news with positive test rates starting to decline in the UK and the number of patients on a mechanical ventilator declining to its lowest level in three months. This supports the argument that the Omicron variant is milder than previous iterations. The UK acts as an interesting test case given its high vaccination rates, high Omicron cases and relatively light restriction measures.
Outlook: Update on Chinese growth, UK inflation, Bank of Japan meets, Q4 earnings season continues in earnest
The data releases are slightly lighter in the week ahead, with the US markets also closed on Monday for Martin Luther King Day. China will provide their Q4 GDP as well as December’s industrial production and retail sales numbers which will provide a useful update as to the impact of both the pandemic and regulatory crackdown upon growth. On the inflation front, the UK will release its December CPI print (5.3% expected), while the expected figure is substantially below the 7% print in the US it would similarly be the highest inflation print since 1992, is well above the Bank of England (BoE) 2% target and is the last inflation print ahead of the BoE's next rate decision in early February. The Bank of Japan is also due on Tuesday, although no material announcements are expected. Finally, earnings season will pick-up, with 39 S&P500 companies reporting, including Goldman Sachs, BNY Mellon, Bank of America, Proctor & Gamble and Netflix. The results season will potentially be a useful update as to how companies are coping with both the impact of the Omicron variant as well as the inflationary surge and its impact on demand and margins.
- Markets react to FOMC meeting minutes; investors rotate into value
- Omicron variant displaces Delta; initial studies indicate decreased severity
- PMIs fall marginally; early indications the worst of supply bottlenecks may be over
- Outlook: Inflation data, earnings season begins, Fed Chair nomination hearings
Markets react to FOMC meeting minutes, investors rotate into value
The main event this week came from the release of the minutes of the FOMC meeting on December 15. While the result of that meeting was to double the pace of tapering and effectively end the quantitative easing (QE) cycle in March 2022, the minutes revealed a more hawkish Fed than previously thought, with discussions being had over a reduction of the balance sheet (quantitative tightening). Furthermore, at least three rate hikes are expected in 2022, as the Fed looks to control inflation, which has proven stronger and more persistent than previously expected. Markets reacted sharply to the news, with a selloff in bonds, driven by real yields, and equities with the S&P 500 and Nasdaq indices both falling on the news, ending the day -1.94% and -3.34% respectively.
Noticeably, there has been a strong rotation from growth into value at the start of the year. A derivative of the Fed minutes is the implication that it believes the economy is strong enough to begin discussing a tightening cycle. Data releases during the week support this, starting with the ADP employment report showing the US added 807k jobs in December, well above the expectation of +410k and the +505k in November. The payroll figures from Friday were below expectations, however revisions to the prior two months added +140k to those figures. In light of this, the unemployment rate dropped to 3.9%, its lowest level since February 2020. A strong growth outlook typically favours a pro-cyclical tilt, which explains the rotation by investors into value stocks. Our view is that the growth outlook, even in a rising rates environment, favours positive broader equity market returns. The key risk is a rate of change of yields that is too fast, and so we will be watching this closely.
Omicron variant displaces Delta, studies show decreased severity
The Omicron variant has proven far more transmissible than Delta, as the Center for Disease Control and Prevention (CDC) reported that over 95% of sequenced cases in the US were Omicron. This is a stark difference to the beginning of December, when Delta represented 99% of sequenced cases. Cases are spiking in most areas, with the US, UK, and parts of Europe reporting record high numbers. Markets so far have looked through this, with many seeing this as the next step in the path to a post-COVID world. Many indicators are now pointing to the Omicron variant being less severe, with the risks of serious illness and overwhelmed healthcare systems lower. Dr Anthony Fauci stated in a press conference on Wednesday that “multiple sources of now-preliminary data indicate a decreased severity with Omicron”, further citing a study indicating the risk of hospitalisation or death from patients with Omicron was 65% lower than those who had contracted the Delta variant. The likely scenario then for 2022 is a continued recovery in economic activity.
PMIs marginally fall, Omicron impact below expectations
Eurozone PMIs for December indicated an easing of activity in the services industry, as the effect of rising virus counts began to show. The Markit Eurozone services PMI came in at 53.1 (vs 53.3 expected and prior), with a particular slowing in Spain (55.8 vs 59.8 prior). The deceleration in activity, caused by renewed restrictions in the winter period, is expected to be felt in January too. On the manufacturing side, the surveys were broadly flat and, given the expected impact of Omicron, this implies economies have dealt well with the impact of the new variant. Some of the more recent headwinds from supply chain bottlenecks showed signs the worst may be over, with a drop in the number of producers reporting lower output due to component shortages, while other headwinds faced by companies include continued cost price pressures.
Outlook: Inflation data, earnings season begins, Fed Chair nomination hearings
There will be plenty to look out for next week, with the highlight being inflation prints in the US, China, and parts of Europe. The current consensus is for YoY CPI to surpass 7% in the US for the first time since 1982 and it will be a key topic of the FOMC meeting later in January. Additional noticeable data releases include retail sales and industrial production, which are expected to come in below prior readings. Earnings season kicks off next week with a number of large US banks such as Wells Fargo, JP Morgan Chase, and Citibank reporting. Another to keep an eye on is Delta Air Lines, which will provide some insight into the effect of Omicron on the airline industry. Finally, the nomination hearings for Jerome Powell’s and Governor Brainard’s appointments as Fed Chair and Vice Fed Chair, respectively, will be taking place.