After 18 months of Covid-19, an iteration of the virus – Delta – is delaying a return to (a form of) normal life and, to some extent, ruining the summer. It would be tempting to view recent market movements through this lens. This would ignore the one question investors should ask themselves to be ready for the autumn: What is the US Federal Reserve going to announce next?
After all, US economic growth has been strong. Inflation may take hold for longer than expected at above 2%. What will this mean for the next steps in US monetary policy?
Where practised, genomic sequencing of SARS Cov-2 variants shows that the highly contagious Delta variant is now behind all or almost all new infections in countries such as Switzerland, Germany, the UK, India, Spain – and the US. At the same time, studies confirm that vaccination remains effective as it protects against serious forms of disease, thus limiting the number of patients in intensive care.
Even if, due to the contagiousness of this strain, the threshold for achieving herd immunity has been raised, countries with high vaccination rates should be able to overcome this new wave without drastic measures such as full lockdowns.
The effects of Delta on economic activity are therefore likely to be modest unless pandemic fatigue or fear, or a fall in consumer and business confidence, throw up new hurdles to the recovery.
The epidemic is now affecting regions that had been relatively spared so far. This is particularly the case in emerging Asia. Although the peak appears to have been reached in Indonesia or Cambodia in mid-July, the number of infections has continued to rise in Vietnam, Laos and South Korea. In China, the number of cases has jumped to its highest since January.
These developments have led some countries to question the ‘zero Covid’ strategy that had been successful so far in blocking the spread of the virus by radically isolating the affected people and territories. The more contagious Delta makes this approach more hazardous from a public health point of view, while it weighs directly on economic activity.
Rapid vaccination progress allowed Singapore (66% of the population fully vaccinated on 8 August, up from less than 40% in early July) to drop its zero Covid strategy, ease constraints on travellers returning from abroad, and announce that it would label the virus endemic once 80% of the population was vaccinated (by September, according to the authorities).
Such decisions are, of course, crucial to enabling emerging economies to reopen as developed countries did. However, they can also give rise to further mutations if they occur at a time when vaccination rates are insufficient.
The risk is that another new variant will prove resistant to vaccines. Beyond the tragic health consequences, investors do not seem to have priced in such a possibility at the moment at all.
The 10 August record by the S&P 500 equity index does not change the fact that the trend in the main indices has been less clear since May. The latest rise involved only modest investor participation. Another element points to a (over)stretched market: There was no significant capitulation before the rebound since 19 July. Overall, this uptrend looks fragile in the short term.
From the end of July, global equities have gained 1.1% (MSCI World index in USD as of 10 August). After losing 7% in July, emerging equities are up by 1.8%. 10-year US government bond yields rose by 13bp to 1.35%. The 10-year Bund yield, which on 4 August had slipped towards the ECB’s -0.50% deposit rate, rose to -0.45%, leaving it virtually unchanged from end-July.
The last few days have also seen a rapid fall in commodity prices, including gold. The US dollar (+1.4% vs. end July) reached its highest since end-March against the euro. Expectations of (a tighter) monetary policy by the US Fed largely explain the advance.
Exhibit 1: The US dollar has moved upwards
The latest US jobs report was strong across the board. After revisions, net job creation came in at nearly 1 million in June and July.
Is this “the substantial further progress towards the full employment and price stability targets” that the Fed has set as a precondition for reconsidering its USD 120 billion a month in asset purchases in pandemic support for the economy?
Last December, when the Fed set this hurdle, total employment was 10 million below the pre-pandemic level of February 2020. This gap has now narrowed by more than 40% in a few months.
While there still is a shortfall relative to February last year, some members of the Federal Open Market Committee (FOMC) have suggested that another month of strong job growth would be sufficient to consider that ‘substantial progress’ has indeed been made now.
Exhibit 2: Has the improvement in US employment since December been substantial?
Jerome Powell’s position is probably more nuanced, but the Fed chairman will not be able to avoid a compromise at the FOMC meeting on 21-22 September by saying, for example, that economy is nearing ‘substantial progress’. Ahead of that FOMC meeting, the 26-28 August Jackson Hole symposium of central bankers could be an opportunity to prepare the ground.
In addition, recent comments by Fed vice-chair Richard Clarida have poured cold water on the notion (held by Powell and other central bankers) that inflation is currently going through only a temporary spell of acceleration. Core personal expenditure prices — the Fed’s preferred inflation metric — have been rising at a 2.7% rate since February 2020.
“If, as projected, core PCE inflation this year does come in at, or certainly above, 3%, I will consider that much more than a ‘moderate’ overshoot of [the FOMC’s] 2% longer-run inflation objective.”
Fed vice-chair Richard Clarida
The Fed vice-chair says, “Necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022”.
The timing and direction of the next Fed decisions will remain a key focus for investors over the summer and into the autumn.
For markets across asset classes, how the Fed communicates on its course will be crucial, particularly in the short term, given their (technical) vulnerability to a correction.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions). For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.