The recent publication of the minutes from the November meeting of the US Federal Open Market Committee (FOMC) showed most members favouring slowing the pace of policy tightening, reinforcing market expectations of only a 50bp rate rise at the 14 December meeting. On account of this news, along with benign developments elsewhere, the market’s mood took a turn for the better. That said, other issues continue to prompt debate among investors, creating market volatility.
Among the developments that improved market sentiment were the UK Prime Minister’s ushering in of fiscal austerity to restore market confidence, and Beijing’s apparent policy pivot to ease the two biggest drags on Chinese economic growth, namely its zero-Covid policy (ZCP) and the property market’s woes.
On the political front, the reconciliatory tone of the Biden-Xi meeting at the G20 summit in Bali helped reduce a range of concerns. These include the risks arising from a possible severing of US-China technological ties, tensions over Taiwan and the possibility of draconian sanctions by the US against China.
The result was a reduction of the stress on global risk assets.
It’s still inflation, stupid
Despite investors’ initial excitement, there was actually nothing much new in the FOMC minutes. US Federal Reserve Chair Powell has been clear in his recent speeches that after four consecutive increases by 0.75 percentage points of the key policy rate, the Fed would start to deliver smaller rate increases, although the terminal rate of this tightening cycle would be higher than previously thought.
“The time for moderating the pace of rate increases may come as soon as the December [FOMC] meeting,” Powell said in his latest speech. “[We] do not want to overtighten because…cutting rates is not something we want to do soon.” At the same time, he noted the labour market “shows only tentative signs of rebalancing…wage growth remains well above levels that would be consistent with 2% inflation. Despite some promising developments, we have a long way to go in restoring price stability.”
At the time of writing, the real fed funds rate was -4.6%. Compared with its long-term average of about 1% (see Exhibit 1), the prevailing real rate is too low to effectively bring inflation down to the Fed’s 2% target.
Record Black Friday sales last week (amounting to more than USD 9 billion) did not argue for a shift in the tight policy stance. So, arguably, the Fed is not done with raising US interest rates, though the pace of policy rate increases may slow.
The same goes for other major central banks. There are still more Fed and ECB hawks than there are doves. For example, St. Louis Fed president Bullard argued recently that rates should rise to above 5.0%, or even as high as 7.0%, before any slowing of the tightening pace. ECB executive board member Isabel Schnabel has argued in favour of another (it would be the third consecutive) 75bp rate increase at the 15 December policy meeting, citing concerns about fiscal spending boosting demand beyond supply capacity.
Even in Japan, inflation rose to a more-than-30-year high of 3.7% recently. A number of hawks at the Bank of Japan (BoJ) want to raise policy rates to shore up the yen in foreign exchange markets. The yen has however, rallied back from 32-year lows versus the US dollar on market speculation the US central bank will slow its rate increases.
Globally, inflation is still way above many central banks’ targets. In the UK, for example, it is running at a 41-year high of 11.1% year-on-year (YoY). Inflation in the eurozone fell for the first time in 17 months, raising hopes that the price surge has peaked. A slowdown in energy and services prices helped eurozone inflation fall by more than expected to 10% in November, down from a record 10.6% in October, according to data from the EU’s statistics agency.
The path of interest rates depends on whether price pressures are really subsiding. That is far from clear. Smaller central banks have signalled that their hawkish policy stance may continue. Last week, the Reserve Bank of New Zealand (RBNZ) and Sweden’s Riksbank both sped up their tightening, raising rates by 75bp rather than 50bp. The RBNZ even debated the merits of raising rates by 100bp.
Crosscurrents and stagflation
Meanwhile, emerging signs of economic weakness have raised concerns about recession. We note that 60% of the US yield curve is inverted, implying rising risk of recession. A divided Congressional leadership (with the Republicans controlling the House of Representatives and Democrats the Senate) will likely limit the extent of any fiscal support while the risk of recession is mounting. Europe and the UK are also widely expected to fall into recession in the near term.
No surprise, then, that investors have been whispering about stagflation. Indeed, financial markets have recently moved to price alternating concerns over inflation and recession, resulting in high volatility. So, after the knee-jerk gains on slower-than-expected US inflation, the Fed’s statement on slowing the pace of tightening and a potential Chinese policy shift, equities gave back all their gains in the past week.
Covid resurges in China
The resurgence of Covid cases in China (see Exhibit 2) is adding to market concerns about the slowdown of the world’s second largest economy aggravating global recession risk. The recent demonstrations in many Chinese cities against the Covid lockdown measures hit market sentiment further.
Since stamping out Covid infections is still the ultimate directive from Beijing against which the performance of local officials is judged, a relaxation of the Covid restrictions looks unlikely any time soon despite Beijing signalling that zero-Covid policy measures could be eased.
The surge in cases has raised doubts over when China can truly exit the ZCP. A market proxy for this policy, the Bloomberg commodity index for industrial metals, has given back half of the initial gains it delivered last week on Beijing’s policy pivot signal.
Meanwhile, China has taken concrete action to support its property market. The People’s Bank of China approved RMB 200 billion of interest-free loans, mostly for developers. It followed this move by cutting the bank reserve requirement ratio (RRR) by 25bp, releasing RMB 500 billion into the system.
The RRR cut reduces financing costs for lenders, who the government expects to support property developers. It also serves as a signal to boost confidence in view of the prevailing Covid policy uncertainty (we note that the last RRR cut came during the Shanghai lockdown in April). Unfortunately, the pandemic has not yet turned the corner, leaving investors in doubt over the credibility of a ZCP exit plan.
In a nutshell
A slowdown in the pace of policy rate rises is not a panacea for all the market’s ills. There are too many moving parts in both economic fundamentals and central bank policies, so we remain cautious on equities. The world is heading towards recession, with some countries facing higher stagflation risk than others. Overall, we are neutral with regard to our exposure to equities.