In the thick of the tightening
The Fed is doing a good job now, putting up rates along the path that it has successfully set out for the market. There is still a long-way to go to the peak, but it is always the travelling that is the most treacherous to navigate. This was illustrated by the Bank of England hiking rates and talking about negative growth. Bigging-up stagflation is no way to calm markets. The ECB is now in sight and, as inflation peaks, the growth numbers will dominate. Things could get worse for risky assets.
The US Federal Reserve delivered a much telegraphed 50 basis points (bps) hike in the Fed Funds rate this week. Chairman Jerome Powell also downplayed the risk that rates might be increased at a 75bps pace at subsequent meetings. As a result, markets re-priced some of the path of expected rate hikes for the remainder of this year and into 2023. However, the market still sees an additional 200bps of rate increases before the end of 2022 and is priced for a terminal Fed Funds rate of around 3.25% by Q2 next year. I imagine the Fed is fairly comfortable with the tightening of monetary conditions that has already happened as a result of officials sending more hawkish messages in recent months. Rate expectations are above 3%, bond yields have moved higher and corporate borrowing costs, for BBB-rated companies, are over 250bps higher than the low seen last summer.
The most recent period of such aggressive monetary tightening was 2018. Equities and credit delivered negative total returns for the year as a whole and the second half of that year was quite nasty, especially when growth indicators started to weaken. Looking at some risk indicators – real US yields, inflation break-evens, the Italy-German sovereign spread, the Euro crossover CDS index, the emerging market debt spread and the VIX equity volatility index – some, but not all, are already at 2018 peak levels. This is most evident with credit indicators with the crossover index and the emerging market debt spread already higher than the peaks achieved in 2018. Real yields, equity volatility and the BTP-Bund spread have some way to go. Additional downside risks to all markets can’t be discounted as momentum points to possible further increases in bond yields and further declines in stock prices. The stagflation narrative is also a major negative.
Hard to find positives
Using our macro-valuation-sentiment-technicals (MVST) framework for judging the outlook for different markets, I would say that the macro factor remains negative across the board. Inflation may be peaking but will remain high, growth is slowing under the weight of the household real income squeeze and broad-based input cost inflation, and policy is being tightened. These factors have already combined to deliver negative returns across asset classes so far in 2022. The upside of this is better valuations. Bond yields and spreads are higher and equity ratings have come down significantly since last year. Sentiment remains quite poor – judging by market commentary – and I would not expect sentiment to significantly improve until there is some cessation of hostilities in Europe, until energy prices start to fall and until there is a clear peak in annual inflation rates. The Bank of England, in delivering its fourth consecutive rate hike, did so while warning of higher inflation and weaker growth! That triggered a negative market response in both global bond and equity markets. No-one wants stagflation. As far as technical factors go, volatility and liquidity don’t help at the moment and, for fixed income investors, there is the uncertain impact on market pricing that will come from central banks reversing out of quantitative easing and reducing their balance sheets. Overall, the MVST scoresheet is marked by negatives for most factors.
Let me try and be positive. Oil prices remain high but have essentially traded sideways since the middle of March, with Brent crude spot prices in an approximate range of $100-$110 per barrel. Natural gas prices are generally lower. Thus, the big upward impact on inflation from energy is passing and that will contribute to lower year-on-year inflation rates. It will be interesting to see what the April consumer price report from the US brings. Core consumer prices rose by 0.5%-0.6% per month between October and February. March saw a drop to a 0.3% monthly increase. The current Bloomberg consensus is for 0.4% in April. It may be that momentum in core inflation is also easing (however there has not been much relief in pipeline pressures if the producer price index is anything to go by). The Fed has hiked by 0.75% and has been successful in steering monetary conditions tighter. The dollar is at an almost 20-year high against other major currencies. I repeat my opinion from last week, the Treasury market offers an opportunity to add duration at these yield levels. If, at some point, growth cracks and rate expectations reverse, a 1% move lower in Treasury yields will deliver a 7-8% total return. One might need that if equities take another fall.
The Bank of England again punched above its weight. It hiked rates to 1% this week but also talked about a significant growth slowdown. This was not met well by markets and was the butterfly wing flap that sent the Dow Jones Industrial Average down by more than 1,000 points on May 5th. Moreover, the monetary policy committee was fractured in its views with three members calling for a 50bps hike (hawkish) and some even suggesting that a more balanced outlook for growth and inflation was warranted (dovish). It has been said to me on more than one occasion that there are big differences in the way the FOMC and the MPC operate. In the US, the chairman solicits views ahead of the policy meeting and diplomatically seeks a consensus that is likely to be close to what has already been messaged to markets. In the UK, the MPC has more of a sleeves rolled up heated debate. No wonder there is more of a history of dissension. Split decisions and stark warnings on the outlook don’t sit well with the expectations of teenage scribblers. The growth/inflation mix is likely to be worse in the UK over the next year or so. The Bloomberg consensus is for UK growth of 3.8% this year and 1.6% in 2023, with inflation expected to average 7.1% and 3.4%. This is more “stagflationary” an outlook than the 2.1% growth and 2.8% inflation forecasts for the US in 2023. There is also scope for more uncertainty on the political side which all adds up to not being very bullish on sterling. Another test of $1.20 is likely in the currency markets – a repeat of the lows seen in 2016 after the Brexit vote, 2019 and in 2020 when COVID struck. British prime ministers don’t tend to survive a sterling and inflation crisis and the local council elections don’t appear to have gone very well for Boris.
Now that the Fed and the Bank of England have done their May rate hikes and the market is becoming even more skittish about the growth outlook, settling on the view that the Fed is likely to raise rates another 50bp in June, attention will focus on the European Central Bank. It has become a strong consensus that the first rate hike could come in July. The ECB is behind the curve considering that 10-year benchmark German bund yields have already risen by 150bps since last summer. Negative interest rates aren’t doing much for the Euro Area economy and remain something of a nuisance for the banking sector. So, the ECB needs to move and get rates to at least a positive level, otherwise it risks a much weaker Euro than it already has. The market is pricing 80bps of rate hikes this year, which would be incredible given the bias of the ECB in recent years. One of the risk indicators that remains well below its 2018 level is the Italian-German government bond spread. It is currently at 190bps with Italian 10-yr yields at 2.86%. The increase in spread has not been driven by any particular Italian systemic issue but more by the broader inflationary and monetary tightening backdrop. With asset purchases coming to an end, the last thing Europe needs is a re-run of a sovereign debt crisis. It’s thus important that the ECB is credible in getting back ahead of the inflation picture in order to contain the increase in rates. If not, then questions about debt sustainability will emerge. Italian growth is not strong enough to cope with borrowing costs much higher than they are at the moment.
My own view on bond allocation then is to favour the US over Europe and the UK. Yields are higher and have already moved a lot in response to potential tightening. The dollar is strong, and, in the near term, it is hard to make a case for a Euro or sterling revival. Growth is weaker in Europe as well, so from a credit standpoint there is more risk, especially if the sovereign debt-bank debt relationship comes back into focus.
Oil profits need to finance renewables
The two huge oil majors listed on the UK stock market reported this week. Earnings surprised on the upside sparking even more political debate about taxing the energy sector in order to finance investment in renewables and help soften the rise in energy prices to households. It comes down to political will whether there will be windfall taxes on energy companies. However, it is important that investors also engage with the companies to ensure that the economic rent gained from the increase in prices is channelled towards developing these companies own renewable businesses. It should be working like this. The high direct cost of fossil fuels (not to mention the intolerable indirect costs) should accelerate the shift towards renewables which are now more efficient in generating electricity. If the market doesn’t facilitate that shift, policy needs to do more. The push-back on the net zero agenda from some quarters is dangerous and the virtues of cleaner, more reliable and less politically toxic energy in the future is a story that needs to be told more aggressively.