Monday Digest

Posted 23 December 2024

Fed spoils the Christmas party
Investors weren’t expecting the Federal Reserve’s hawkish forward guidance adjustment (fewer interest rate cuts to be expected in 2025) and sold off sharply on the news. That is a big change from last year’s unstoppable ‘Santa Rally’, but in other respects we end 2024 similarly to how we started: coming off a good year for returns, unsure of whether it can be repeated. UK yields also rose to their highest this century, partly because of the Fed and partly because the Bank of England kept rates on hold.

The Fed surprise isn’t really a surprise, given US economic strength and Donald Trump’s promised pro-growth policies. We didn’t expect such a sudden hawkish shift – but we did say markets were too optimistic about US rates. Interestingly, the US mega-tech stocks suffered the most, despite being cash-rich and (on paper) immune to higher debt costs. That suggests the sell-off was a valuation correction, rather than economic pessimism.

We suspect one reason markets didn’t think the Fed would turn hawkish was that it will inevitably upset Trump. A fight over Fed independence now looks likely, and it’s not the only fight the new administration is gearing up for. Trump adviser Elon Musk sharply criticised a bipartisan budget deal that congressional Republicans just agreed, suggesting that Trump 2.0 might see the kind of government shutdown threats that used to plague Washington.
These policy headwinds are not (yet) disturbing the strong outlook for US profits. It looks like US exceptionalism will continue which, combined with Fed hawkishness, is bullish for the dollar. But, it was notable that US stocks (particularly tech) got the biggest knock-down this week, probably because of investors’ previous American optimism. US dominance creates longer-term problems but, for now, this week’s price correction makes stock valuations look healthier. That sets up the start of 2025 nicely.

How long will the BoE stay still?
The Bank of England (BoE) was in no giving mood before Christmas, holding interest rates steady last week. Markets expected as much, after November’s data showed higher wage and price inflation than the previous month. Worryingly, inflation remains while growth is weak. UK bond yields remain higher than elsewhere because investors doubt the BoE will be able to cut interest rates as sharply as other central banks. The difference between market expectations for UK and Eurozone rates is particularly stark: markets predict Eurozone rates at 1.75% by the end of 2025, while Britain’s rates are predicted to remain above 3.5%.

We are sceptical of this mismatch, though. UK yields are even higher than the US, but judging by relative growth and fiscal policies, it’s hard to make the case that Britain needs tighter monetary policy than the US. The UK has a similar inflation profile to Europe, but markets think the ECB has prices under control and the BoE doesn’t. This suggests the BoE has more scope to cut than currently expected – or that Britain is set for surprisingly high inflation.

The latest inflation numbers, while higher than October, weren’t a surprise. In fact, core (excluding volatile elements) and services inflation were below expectations, and these tend to better indicate the medium-term outlook. This isn’t to say everything is fine (housing costs and wages are a concern) but we suspect the BoE will ‘look through’ these numbers. For example, overall employment declined, despite the wage rises.

The BoE is more wary than most about supposedly ‘transitory’ supply-led inflation, so they will continue to wait and see. But the data they are waiting to see will probably be weak. That could mean more UK rate cuts than bond traders currently predict.

Chinese stimulus good, not great
China’s economic stimulus continues to underwhelm. Beijing recently announced a fiscal deficit expansion which implies RMB 1.3 trillion ($179.4bn) in extra spending, but Chinese stocks only bounced slightly and later pulled back. Weak growth – as shown by November’s disappointing retail sales – is taking the shine off policy promises, and those promises themselves are doubted. Markets doubt Beijing’s willingness or ability to solve its domestic demand problem. The clearest example of this is that Chinese government bond yields fell despite announcing new issuance.

It’s important to see the wood for the trees, though. Beijing has significantly increased its economic support since the summer and policymakers are taking the domestic demand problem seriously. In the past, stimulus was concentrated on production, which only exacerbated the supply glut, despite maintaining official GDP numbers. Previous spending also came through local governments, which have proven themselves incapable of investing efficiently.

China needs private companies to spend more, but leaders are afraid of that, after the credit and property bubbles they inflated in the 2010s. It does seem like Beijing now recognises the necessity of private sector expansion, judging by its recent cuts to key policy rates (with more expected soon). Money creation numbers suggest this is starting to work. People are moving money into current accounts, which is usually a sign they are set to spend rather than save.
It will soon be crunch time for Beijing. Once Donald Trump enters the White House (January 20) we will find out whether his “day one” tariffs are serious. That will quickly be followed by Chinese new year and the spring festival, during which we will get a better sense of whether demand stimulus is working. There are reasons to be hopeful, but it’s time to deliver.