Equity markets have continued their recent see-saw pattern. Global equities fell some 1.5% last week, after a gain of 3% the previous one, and are down a further 1-2% this morning. If today’s declines are carried through to the US, this will leave markets off around 4-5% from their mid-November high.
The latest decline has been triggered by renewed nervousness about Omicron on the back of the wave of restrictions being introduced in much of Europe, with the Netherlands now back in full-scale lockdown. Restrictions could clearly be tightened further, dealing a nasty blow to the hospitality and travel sectors.
Even so, we continue to believe Omicron represents only a temporary disruption to the ongoing economic recovery. As one investment bank succinctly put it, Omicron should delay and divert rather than destroy demand. There is mounting evidence that booster jabs are effective and anti-viral pills will also help reduce hospitalisations. It should also not be forgotten that economies have become much more adept at dealing with covid spikes over the last two years.
Certainly, Omicron did not dissuade the Fed and the BOE from tightening policy last week. The Fed as expected sped up the pace of its QE tapering, with bond purchases now set to finish in March rather than June. It also upped its forecast to three interest rate increases next year.
Chair Powell, however, played down the extent of the hawkish swing by the Fed and 10-year Treasury yields ended the week a little lower. Whereas the Fed is forecasting that rates eventually rise to 2-2.5%, the market sees them peaking at less than 1.5%.
We are not convinced that such limited tightening as the market now expects will be enough to bring inflation down close to the Fed’s 2% target. If we are right, 10-year US Treasury yields, which are back to 1.4% from a high of 1.7% earlier in the year, should in due course resume their upward trend.
Meanwhile, the BOE sprang a Christmas surprise on the markets, raising rates in December for only the second time in 45 years. It unexpectedly voted by 8-1 to raise rates from 0.1% to 0.25% and believes further modest tightening will be required. Two main factors were behind the MPC’s decision.
First, inflation has continued to surprise on the upside. Consumer price inflation hit a 10-year high of 5.1% in November, with the core rate (excluding food and energy) rising to 4.0%, the highest level since 1992. The Bank now expects inflation to peak as high as 6% in the spring, before then falling back.
Second, the labour market remains very tight despite the end of the furlough scheme. Job vacancies are at a record high and the unemployment rate has fallen to 4.2%. The fear is that the current combination of high inflation and a tight labour market could fuel a wage-price spiral.
The ECB, by contrast, produced no surprises last week. It will continue with its QE program next year, albeit at a reduced pace, and doesn’t intend to start raising rates before 2023. As for the PBOC (People’s Bank of China), its policy is out of sync with the West and rates were lowered slightly today.
Chinese growth has slowed significantly following an early rebound from Covid and policy is now being relaxed a little. This is in an attempt to support the economy and offset the drag coming from the property sector as a result of the ongoing demise of Evergrande, the property developer.
Elsewhere, interest rates have generally been heading higher, albeit with the odd notable exception. Brazil for instance raised rates by 1.5% earlier this month to deal with spiralling inflation, whereas Turkey cut rates by 1% in an unorthodox bid to deal with the exact same problem.
As far as global equities are concerned, the direction of travel is clear. Central banks are now starting to unwind the massive policy stimulus unleashed during the pandemic. This is liable to lead to further market volatility and limit the extent of future gains in equities on the back of further increases in corporate earnings.
Even so, as discussed last week, equities still look set to outperform bonds next year and we retain our constructive pro-equity stance. I will end this commentary, the last of the year, on that positive note and wish you all a merry festive season and a prosperous New Year.
Chief Investment Officer