Ouch and happy holidays
The central banks are coming. The Bank of England was the front-runner in terms of rates with the Federal Reserve set to get ahead in winding down bond purchases. It’s a meaningful change in the setting of global monetary policies. But it’s no taper-tantrum and no rate shock. For now, bonds and equities can continue to perform but the big risk is that markets have collectively mis-priced what could be an unusual tightening cycle.
Central banks delivered a slap on the hand rather than a punch to the ribs but the message was clear, nevertheless. They are girding for the battle against inflation. Next year will see monetary policy conditions tighten. This is coming a little earlier than would have been the case if inflation was lower, but it was on the horizon anyway. There is just now more urgency to “normalise” policy in the face of inflation data which keeps surprising to the upside. For now, bond markets are comfortable with the idea that normalisation will be gradual and that inflationary pressures will ease in 2022. The risk is that markets are not pricing the coming cycle properly – understandable as we have never experienced a post-pandemic growth and inflation surge in modern times. What that means is the risks are to the upside for rates.
Not all monetary tightening is the same. In the UK the mantra seems to be “we are the BoE and we’ll do what we want”. In the US, sensitivity around communication means everything is well telegraphed in advance so markets have time to deal with the reduction in bond purchases and the likely three interest rate hikes in 2022. In Europe, it’s hard to get away from the status quo and everything, as usual, is about compromise. The hawks in Europe want a more rapid normalisation, the doves are concerned that this could re-open market fractures and spread widening amongst sovereign issuers within the Euro Area. For all the details of what happens with the Pandemic Emergency Purchase Programme (PEPP) and Asset Purchase Programme (APP), markets are left watching Greek and Italian bond spreads to see whether the European Central Bank can move forward on meeting the challenges of higher inflation in the zone. If the signs are bad, the Euro and European assets will disappoint.
Now we wait
The circling of the central bank wagons does not yet quite constitute a full on attack on current growth and inflation dynamics. Monetary conditions will tighten but from a very accommodative base. And the current end-game is not that challenging for markets. The Federal Reserve is sticking with its long-term terminal rate expectation for the Fed Funds rate of 2.5% (which is zero in real terms given where inflation is likely to settle). European interest rate lift-off is not likely to be in 2022. The futures market has 3-month sterling rates now higher than 1.25% over the next three years. In the short-term this is likely to be how things are. The Fed is not likely to do anything more at its next meeting at the end of January given the very high probability that the Omicron variant will be widespread in the US in the New Year. The same goes for the ECB and the BoE. Indeed, the UK hike sits uncomfortably with daily infection rates heading to 100,000 or more and parts of the economy already suffering again from either government imposed or voluntary social distancing.
Credit not rates
With that backdrop in mind and with the markets having priced at least the near-term likely path of interest rates, risk assets could trade in a relatively stable way over the next few months. A lot will depend on the inflation data of course and the recent re-acceleration of natural gas prices confirm the near-term upside risk. However, our teams just completed the quarterly review of the outlook for a range of asset classes and there was generally a constructive tone for credit, emerging markets and equities. Something that stood out is that alternative credit assets like asset-backed securities and collaterised loan obligations (CLOs). Credit quality is good, spreads on these instruments are attractive relative to fixed rate bonds and they have no duration exposure. In the ranking of asset classes scored by our portfolio management teams using our “macro, valuation, sentiment and technical” framework, leveraged loans, CLOs, small-cap equity and China feature in the top ten for now. At the bottom of the league it is mostly core interest rate assets.
Come on 2022
There’s not much more to be said. It’s been a strange year with people generally trying to behave like normal but always looking over the shoulder to see where the virus was at. Markets have delivered strong equity returns and flat bond returns which, with hindsight, is exactly what should have happened in a world of zero rates and above trend economic growth. We face a bit of a short-term stutter now – they may even postpone the Premier League for a while! And 2022 holds a lot of uncertainty. First with the virus and just how bad or how mild Omicron will be. Second with inflation and whether another round of disruptions will prolong supply-side induced price pressures. Third with politics and the fact that current incumbent leaders in a number of western democracies are struggling. Joe Biden’s popularity has fallen, Boris Johnson has just suffered a humiliating by-election defeat and Emmanuel Macron faces a tough Presidential election challenge. The new German government is unproven, and Mario Draghi might fancy to swap the prime minister’s office for the Presidential one.
So have a great holiday season if you can. Manchester United are COVID-riven at the moment so I have no idea when the Ralf-Revolution will resume but there is a tasty match-up against Atleti at the end of February. Ooh a couple of days in Madrid, that would be nice, that would be normal.