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Monthly Wrap: January 2022

The Christmas New Year is usually a quiet time for financial markets as investors take leave after a busy year. This year turned out to be an exception. Bond yields rose sharply, driven by US inflation data and the Federal Reserve signalling that it would tighten monetary policy much sooner than previously expected. Equity markets, especially US equities, retreated as bond yields increased.

       Written by George Lin
Senior Investment Manager | Colonial First State
   

Key economic developments

While Omicron drove global new case number sharply higher, financial markets’ narrative of the latest wave of the pandemic is significantly different from previous waves. Investors focused on the disruption to supply, not the possible destruction of demand. With the major developed economies adopting a “living with the virus” approach and relying on a combination of mask and vaccine mandates and voluntary social distancing, investors are confident that demand will stay reasonably robust with only temporary, short term weakness. Investors are more concerned about supply side disruption and the impact on inflation for several reasons. Firstly, Omicron has pushed up the level of absentees in the main developed economies and in particular, contributed to the reluctance of workers to return to the labour force in the US. Secondly, China has persisted with a zero tolerance policy and arguably had its worst 30 days since mid-2020. Three Chinese cities, including Xian which has a population of more than 10 million, were locked down in December while Tianjin, a major port city with a population of around 15 million, entered partial lockdown in mid-January. Investors are increasingly concerned that frequent and large scale lockdowns in China will exacerbate problems in the global supply chain.

The most impactful economic data was the December US Consumer Price Index (CPI) which rose 7.0% year on year – the highest annual rise since 1982. On a monthly basis, CPI rose 0.5% which was above the consensus estimates of 0.4% but below the November print of 0.8%. The headline was reinforced by the core inflation data - core CPI in December rose 0.55% month on month, which pushed year on year core inflation to 5.5%. Details of the data indicate that inflationary pressures remain strong and significant falls in inflation over the next few months are unlikely. Core goods prices were again very strong, rising 1.2% month on month with a 1.3% increase in furniture prices, 1.7% in apparel, and 3.5% in used cars. Furthermore, it is not just isolated, logistic-driven rises in good prices which are pushing up inflation. The price of housing, which has significant weight in the US CPI, also rose strongly. Owners’ equivalent rent rose 0.40% monthly while primary rents rose 0.39%.

Source: Factset
Source: Factset

Other US economic data pointed to a gentle slowdown in economic growth. US non-farm employment increased by 199,000 in December, far below market expectation of 440,000. However, strong revisions to employment levels in October and November indicate that US employment growth remain healthy despite a marked slowdown since mid-2021. Furthermore, the US unemployment rate unexpectedly fell to 3.9% in December, relative to consensus for 4.1%. US unemployment rate is now 0.1% below where Fed officials see the long-term sustainable unemployment rate. One contributor to this fall is the low labour force participation rate which was flat at 61.9%. US labour force participation rate has fallen dramatically since the start of the pandemic and, unlike the case in Australia, has not recovered. At the same time, US job openings remained at an elevated level of around 10 million. The data indicates that there is no shortage of demand for labour in the US, but there is a lack of response in labour supply.

Source: Factset
Source: Factset

Similar to the US, the higher than expected Australian December Quarter Consumer Price Index (CPI) data caused investors to reassess the likely path of cash rates. Headline inflation increased 1.3% over the quarter, versus consensus of 1.0%, while underlying inflation rose a whopping 1.0%. At a yearly rate, headline inflation is now running at 3.5%, with underlying inflation running at 2.6%. This is the second consecutive quarter of underlying inflation hitting the Reserve Bank of Australia’s (RBA) target.

The RBA has reportedly stated that its two key conditions for a rate rise are: firstly, sustainable core inflation above its target range of 2% to 3%; secondly, wage increase of more than 3%. Sustainable inflation is widely interpreted as several readings of underlying inflation between 2% and 3%. Hence, the RBA will likely want to see at least one and possibly two more readings of above 2% core inflation before being satisfied that its inflation target has been reached. Wage increases are just above 2.0% but survey based data is pointing to continuing improvement in the job market and hence stronger wage growth. As a result, markets expected and the RBA duly announced an end to its quantitative easing program at its Board meeting in February. Markets also believe the RBA will start raising the cash rate in the second half of 2022.

Source: Factset
Source: Factset

The Federal Reserve, Quantitative Tightening & Financial Markets

Financial markets have had a tumultuous start to 2022, with sharp rises in global bond yields driving significant corrections in equity indices, particularly US equities. The trigger was the Federal Reserve’s (the Fed) “pivoting” and signalling to financial markets an earlier and more aggressive than expected monetary policy tightening.

The Fed’s pivot started in December when the Federal Open Markets Committee (FOMC) announced an acceleration in tapering (reduction in asset purchase), with a target end in March 2022. Investors had barely digested the news when the December FOMC Minutes, released on 5 January, revealed a surprising hawkishness by the FOMC. The minutes suggested that the Fed’s plans to reduce its balance sheet after the first rate hike, in a time frame significantly shorter compared to the almost three year interval between the first rate hike and balance sheet reduction in the last tightening cycle in 2015. The worse than expected December US inflation data reinforced market expectations of an imminent rise in policy rate and a more aggressive policy tightening.

To understand the market’s shock and subsequent reactions, a brief history lesson in the way the Fed ended quantitative easing is required. The Fed ended its last asset purchase program (QE3) in October 2014 after around 10 months of tapering, followed by the first interest rate increase another 6 months later. The Federal Reserve then continued to reinvest the coupons and proceeds from maturing bonds for almost another 3 years, before announcing a reduction in the balance sheet which took around another 20 months to complete. Until January, financial markets had expected the Fed to take a similarly gradual approach, with a first rate hike in mid-2022 followed by a balance sheet reduction starting in late 2023 at the earliest or possibly in 2024. This is now in doubt and markets are now speculating the start of balance sheet reduction may start in 2022, perhaps as early as October.

The Fed’s pivot led markets to aggressively reprice interest rates and bonds. Markets have now priced in an 84% probability of a first rate hike of 25 bps in March and most likely four rate hikes by the end of 2022. Consequently, global bond yields surged since the middle of December. Bond yields rose sharply at the shorter end of the yield curve. The Australian 3 year bond yield rose from 0.93% at the end of December to 1.21% by end of January. The US 3 year bond yield saw an even sharper rise from 0.96% to 1.37% during the same period. 10 year yields also rose globally with Australian 10 year bond yield finished the month at 1.78% after briefly touching 2.01% during January. The other casualty of rising bond yields is equity markets, especially equity markets with expensive valuations and/or sensitivity to yields. The All Ords fell by around 6.6% in January while the S&P 500 fell 5.7%. The NASDAQ fell by an even greater 9.6% in January and entered official correction territory given that it has fallen 11.3% since its recent peak on 13 August 2021. The best performing major equities market is Hong Kong’s Hang Seng, which had languished since mid-2021 but edged out a small gain of 1.7% on the back of further signs of more accommodative policies by China.

Source: Factset
Source: Factset

Forward-looking views

The Federal Reserve has held its February FOMC meeting. As expected, the Fed signalled that a March rate hike is very likely, with the post-meeting statement stating that “it will soon be appropriate to raise the target range for the Federal Funds rate”. Chairman Powell reinforced that at the post meeting press conference by stating that “the US economy no longer needs sustained monetary support”. However, the Fed was vague in terms of its plan on the reduction of balance sheet and did not disclose any detail on timing.

Given the rise in bond yields and fall in equity indices, the most pressing question is whether the current correction is a “buy the dip” opportunity? We are more cautious on this correction than past corrections in 2021. In other words, the correction has to be significantly worse than the 5.2% fall experienced in the Delta outbreak in mid-2021 to justify an aggressive rotation into equities.

The most fundamental reason for our cautiousness is the outlook on US inflation. Similar to most investors, we believe US inflation will moderate over the next 12 months as some of the temporary, supply-side dislocations dissipate. However, we are not confident that US inflation will moderate sufficiently, say to 3.0%, to allow the Fed to turn more dovish and to signal an end to interest rate increases. The risks to US inflation and hence US interest rates are firmly biased toward the upside. While the Fed is not necessarily hawkish, it may conclude that it is more optimal to raise the Federal Fund rate aggressively in 2022 to “nip inflation in the bud”, rather than playing catch up in 2023.

Another source of uncertainty is the Fed’s plan for balance sheet reduction. It has indicated that it would start the process earlier than history suggested but has not disclosed any details. For instance, the Fed’s balance sheet is currently around $8.8 trillion, compared to a pre pandemic level $4.1 trillion. A 50% reduction in the Fed’s balance sheet is unlikely but is a 20% reduction possible? Likewise, whether the reduction in balance sheet takes, say, 12 months rather than 30 months will make a huge difference. The simple answers to both questions are no one knows! Until the Fed provides more guidance on those issues, both bond and equity markets will likely remain on edge and will be volatile.

The second reason for our conservatism is the outlook for corporate earnings. Most developed equity markets staged an impressive recovery in earnings in 2021. While corporate earnings are still expected to grow in 2022, the pace of increase will likely slow according to sell side analysts. This loss in momentum in earnings growth may accelerate over the next 12 months. Lower economic growth, due to both the dissipation of the beneficial effect of the reopening of economies and the impact of higher interest rates, is one factor. In addition, rising input costs and wages (especially in the US) represent another potential headwind for corporate profits. So far, corporates have been able to pass on the input price increases to consumers who have hungrily bought up goods as they emerged from lockdowns. This is unlikely to last forever.

Source: Factset
Source: Factset

There is one argument for not being too pessimistic on the equity outlook. Valuations always matter and falling equity prices are restoring fundamental value to equity markets. The valuations of most developed equity indices have declined in the recent correction. On a forward earning basis, the price earnings ratio of the S&P 500 declined from 21.5 at 31st December 2021 to 19.5 by end of January. The forward price earnings ratio for the All Ordinaries declined from 18.3 to 16.7 over the same period. However, valuations for most developed equity indices are still expensive by historical metrics. Given the broader macro perspective, we believe valuations may have further to fall.

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