Market outlook: a focus on interest rates

17 Feb 2022

Market outlook: a focus on interest rates

During the market discussion on the evening after the Fed Chair’s Senate confirmation hearing, Jay Powell described high inflation as a severe threat to the economy and stated that accommodative policies ‘were not needed or wanted’. He also emphasised the need for a long expansion and price stability to deliver full employment and increase the labour participation rate. The Fed have clearly significantly pivoted on interest rates from their thinking in late summer 2021. That week saw Goldman Sachs move to predict four rate hikes in 2022, a stance quickly followed by JP Morgan investment bank.  Bond markets in the short term were pleased with the Fed’s determination to not allow runaway inflation and the 10 Year Treasury yield fell to 1.74% having touched around 1.80% earlier in the week. This rally in US Treasuries occurred even though there was an expectation of a 7% inflation number later in the week which proved to be accurate. 


Sticky inflation

Economic consultancy Gavekal also brought out a piece saying that the Fed see stable prices as necessary for a long cycle. John Authors, formally an FT writer before switching to Bloomberg, noted that since the end of the Volcker era, all Fed hiking cycles had only finished with the Fed fund’s rate above the inflation rate. This begs the question of what inflation will be at the end of 2023 where, if there were eight one quarter point hikes, the Fed fund’s rate would still only be 2.00-2.25%. It seems unlikely that inflationary pressures will dissipate back quickly as there are now more elements of sticky inflation showing elevated pressures. To date, the timing of both the first US rate hike, and the number in 2022 has been brought forward, but there has been no alteration to the terminal rate or end rate of this economic cycle. 


The Federal Reserve now have the tricky task of achieving a ‘soft landing’ for the US economy. This means a slow-down in growth while raising rates far enough to subdue inflation without causing a recession. This is not always easy to achieve as the market hopes and many market participants err on the side of optimism in predicting a soft-landing during rate hiking cycles. 


Prevention of long-term turbulence

Investors have become accustomed to relying on what is described as the ‘Fed Put’ to bail equity markets out if sustained falls occur by easing monetary policy. However, the inflation background makes the ability to cut interest rates and print money (QE) very difficult, almost impossible. The high level of the US equity market, where there has been very significant style rotation, but overall index levels remain close to all-time highs, means a steep fall is unlikely to be seen as so concerning at a time when the economy remains strong. While Powell is aware of the implications of sustained financial market weakness on the real economy, falls from very high levels may be of less concern to the Fed, especially if credit markets remain stable. Furthermore, one wonders if the psychological impact of being seen to bail out equity markets will be reduced after the recent board member trading scandals which has seen three departures, including the high-profile Vice Chair Richard Clarida.  This internal turmoil at the US Central Bank has led some commentators to question how impartial the Fed members can be when they have high exposure to equities and would clearly leave members open to criticism of serving self-interest if it was perceived their measures were benefitting their own personal wealth. The Federal Reserve may now place quelling inflation as their number one priority and deem it necessary to prevent longer-term turbulence in equity markets, even if there are some levels of short-term pain or volatility. 


Sizeable losses

While market indices trade close to highs, another significant point to note is that 40% of the Nasdaq, which is more technology focused, is already down 50% from its highs at the individual stock level. To put this in perspective, the Nasdaq Index (overall) in March 2020 fell 60% from its previous peak in the Covid pandemic, while the tech wreck of the early 2000’s saw a 50-60% pull back and a 70% decline during the GFC. Clearly investors in some stocks are sitting on sizeable losses if they have purchased recently. 


US equity outperformance

The narrowness of the US equity market has attracted much attention with a focus on what has been called the S&P 10, the biggest ten stocks in the Index. Coming to the end of November, the S&P 10 had returned close to 40% while the MSCI World Ex the US market had only returned around 8%. What is less well understood is the performance of the remainder of the US equity market which could be dubbed the S&P 490, or in other words, the Index excluding the ten biggest stocks. These returned, to end November, close to 20% for the year so have significantly outperformed other markets - a factor that many investors may not be aware of. 2021 was a year where US equities substantially outperformed other markets, even excluding the top performing mega caps which delivered such exceptional performance. Being underweight US equities in 2021 was a strategy which simply did not work.


Gamma trading

The most recent week in the market saw the Nasdaq sell off to over 1% on the Tuesday night and then enjoy a significant rally, bouncing to finish marginally higher. For chart followers, the resistance and bounce off the 200-day moving average, which sits around 14,600, would be seen as significant. These intra-day swings have been highlighted as being driven by option trading and positioning and something referred to as Gamma Trading, which is well away from fundamental investment strategies and makes reading short-term market moves highly difficult.


Omicron & economic rebound

While Omicron case numbers are extremely high, looking at South Africa and parts of the UK such as London, there are early indications that it burns through relatively quickly and this will have implications for economic activity not too far down the road. If Omicron passes through quickly, there could be a further surge in consumer spending, this time potentially more targeted at services.

The Fed has undoubtedly pivoted from its previous stance on rates, but the foot remains firmly on the accelerator with real rates negative at a time of 7% inflation. There is now a risk that the sticky components of inflation, including the rental element and other service sector inflation, means that, even if manufacturing bottlenecks and supply side pressures ease, inflation will not fall back to pre-pandemic levels quickly. The evidence remains that the US Federal Reserve is still behind the curve and, therefore, there is a risk that they will be forced to do more than the market thinks on interest rates.  Markets are responding quickly to data and headline news flow, and it might prove that good news is bad news for the markets if Omicron is short-lived and economic activity rebounds faster than expected, pushing bond yields higher. A US Treasury bond yield of around 1.75% does not seem to offer much long-term value. With more monetary tightening likely in 2022 than expected at the start of the year, looking at consensus forecasts for US rate rises, you might have expected the US currency to be strong, but in fact it seems to have decoupled from growth in the short-term, partly because most investors were long of the US$. 


Currency & bond yields

Looking forward there are positive and negative arguments for the US currency. With the US hiking rates it will be a high yielding currency with positive carry but while US rates are rising, real rates remain highly negative, and the actions by the Fed are too slow to deal with the inflation problem. If the latter view prevails, US currency weakness would likely occur. The markets have initially rallied on the Powel statement, but the big risk remains that a further upward spike in bond yields will hit equities again this year at some point.


Graham O'Neill, Senior Investment Consultant

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