By Tim Sharp
November started with an FOMC meeting that confirmed the arrival of balance sheet tapering at the expected rate $15bn per month, although Chair Powell did give himself some flexibility to be able to adjust the pace of the taper in 2022. Mid-month it was confirmed by President Biden, after much speculation, that Jay Powell would retain the Chair for a further 4-year term with the other candidate Lael Brainard being offered the vice Chair position, thereby providing a sense of stability at this time of transition.
The November jobs report was strong with the Covid affected Leisure and Hospitality sectors also seeing some recovery which is encouraging. The JOLTS data[i] also showed that 4.4m people, or 3% of the total US labour force, quit their jobs in September which has been a phenomenon of the second half of this year. Although there are a fair percentage of people leaving the workforce for reasons such as Covid fears, early retirement or lifestyle change many moves reflect a confidence in finding higher paid jobs, suggesting to us that wage inflation may have further to run.
The uncertainty surrounding the response of central banks to inflation will continue to influence investors as the transitory nature of the near-term rate feels increasingly persistent, with wages and rental income looking to have gained medium term momentum. Owners’ Equivalent Rent (OER) makes up about 34% of the CPI basket and the ongoing strength in house prices provides a tailwind for rent rises to remain persistent. Moreover, the market is beginning to price in future rate hikes with 3 hikes now priced in for 2022, making 5 or 6 hikes expected by the end of 2023 we believe, which is more aggressive than speculation in September or October. This also suggests that the market expects tapering to be more aggressive in 2022 if this timetable of interest rate hikes is to prove accurate and this was confirmed by Fed Chair Powell during his testimony to the Senate Banking, Housing and Urban Affairs Committee yesterday. We are surprised by the nature of this turnaround and believe that the markets may be pricing in the prospect of a Fed misstep as much a fear of persistently strong inflation.
In the UK the Bank of England Monetary Policy Committee surprised the markets by leaving rates unchanged in November having guided in October of their intention to hike boosting market volatility at the prospect. As a result, markets had priced in a certain 0.15% hike in November with expectation for an additional tightening during the first quarter. When it came to the meeting, however, Governor Andrew Bailey said the committee needed further clarity regarding employment after the ending of the furlough scheme. This apparent U-turn caused great upheaval in the bond markets and one of the largest one day moves in 5-year gilts since the Brexit referendum. Despite this, markets have still priced in a 1% move by the end of 2022 when growth forecasts are more pessimistic which again suggests to us that the outlook is misaligned.
With bond yields drifting higher but not matching the rate tightening expectations we believe the environment remains more favourable to equity investment. Bond yields remain low versus equity yields which favours the economy and equities from a relative valuation perspective. Absolute Strategy Research (ASR) analysis suggests 10-year US Treasury yields would need to rise above 2.5% (1.5% currently) to pose a significant risk to equities and modestly higher yields can also support a rotation into more value orientated companies without undermining equity markets overall[ii]. Despite the inflation headlines and central bank uncertainty equity markets have largely remained unruffled even though many companies have guided to lower earnings growth in the fourth quarter. Investors may be concerned about supply chain disruption and rising wages squeezing earnings but, at least historically, periods of wage growth tend to be periods when pricing power is rising for companies so that margins also tend to rise when inflation is above trendii.
However, the reopening story has not followed the expected script in 2020 and much demand has been deferred due to production issues and continuing disruption from the Delta variant of Covid-19. The vaccination roll-out has not been consistent across the developed world and almost non-existent in the frontier markets. Although vaccination rates have picked up sharply in the developing world, we have fears that scarring from the pandemic will have a lasting effect on potential growth rates in the long term. The increased rate tightening expectations in the US have also underpinned the US Dollar – up 2.0% over the month – which creates a further headwind for emerging market investment. The aggressive stance towards Covid outbreaks in China, plus energy shortages and a real estate crisis, have knocked an already slowing economy thereby creating another headwind for global growth, and the developing world. Local government infrastructure spend may provide a much-needed boost to China’s fiscal spending plans, but we feel China as a global engine for growth may take a back seat in 2022.
As we went into the US Thanksgiving holiday equity markets were buoyant, the S&P500 was up 2.1% on the month at 4,701, near all-time highs, and the NASDAQ was similar, although off its peak, as investors undertook another mini rotation out of growth stocks. However, the announcement of another variant of concern, now known as Omicron, first detected in Botswana, caused a significant “risk-off” day when markets re-opened on the Friday with equities, oil, and commodities all significantly lower. Initial investigations suggest the Omicron variant is more infectious than Delta, but there is currently little evidence that it is more lethal, but we live in fear in the developed world that there will come a new variant that is resistant to current vaccines. As global travel routes were closed, many leisure and airline stocks bore the brunt of the sell-off especially as the first signs of the implementation of Covid restrictions in Europe due to the spread of the Delta variant were also hitting the headlines and finding resistance amongst certain elements of their populations.
If the Omicron variant does prove to be vaccine resistant, then we face further social and economic disruption as governments try to persuade the populous to restrict their movements once more. Although it is widely reported that pharmaceutical groups seem confident that they will be able to tweak existing vaccines quite quickly to deal with a new strain. With the weekend to reconsider markets clearly decided that the sell-off was overdone, and many markets and sectors rebounded but remained unstable into month end. Most major equity indices ended November in negative territory as Omicron and Delta met growth and inflation head on, and Chair Powell and Treasury Secretary Yellen offered little comfort during their testimony to the Senate Committee yesterday. The Omicron news also caused markets to move out rate tightening expectations as investors show concern for the implied growth trajectory over coming quarters. Weaker growth may help with the more persistent inflation trends, however, John Authers reports[iii] that according to the San Francisco Fed, pandemic delays and stoppages may drive higher inflation in the goods and services most sensitive to the pandemic, so we conclude that the future path of policy rates in the developed world remains uncertain. Moreover, we do believe that a further wave of Covid-19 will likely affect the developing world harder than the developed world increasing the economic scarring and recovery gap between developed and developing economies. Many economists have shown a degree of optimism regarding the impact of Omicron on the global economy[iv] and, as the data is released, we expect equity market optimism to continue.
[ii] ASR Investment Committee Briefing – November 1, 2021
[iii] Bloomberg Opinion – Points of Return – Risk-Omicr-Off – November 29, 2021
[iv] Financial Time – Economists optimistic on impact of variant – Chris Giles – November 30, 2021
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