Monday digest

Posted 6 December 2021

Summary: fresh uncertainties leave investors second-guessing themselves
As the end of the investing year draws nearer, markets remain on edge. Last week, central bank and government policy, inflation pressures from supply chain issues, and also that virus that refuses to be defeated, threatened to leave investors in a state of puzzlement. Not surprisingly, the new Omicron COVID variant is dominating the news cycle, and the financial press, with new details (and rumours) sending markets spinning in either direction.

While the uncertainty caused by the Omicron variant may well disturb the otherwise positive economic backdrop for December and 2022, we note that the prognosis is much more positive after the experiences of the past two years. Vaccines are now more straightforward, timely adaptable than we could possibly have hoped this time last year. We suspect these wild gyrations are less to do with the virus news itself, and more a case of the “straw that breaks the camel’s back”. After another arduous year, the temptation to close up early, take the money and run is entirely understandable. Omicron offers a convenient (and welcome) excuse for investors to crystalise returns gained in 2021 thus far.

That said, there are plenty of good reasons to stay put and see how things play out. After some weeks of rising concerns about the economic outlook, conditions have started to improve again, and most regional Purchasing Manager Indices (PMIs) have reflected more upbeat business sentiment. While employment indicators have reaccelerated, (notwithstanding a slightly disappointing US figure last Friday), markets are signalling that concerns about the inflation outlook have lessened. Supply chain issues may be fading too. An acceleration of last week’s benign sell-off may or may not happen. But it would be a brave investor who sold now, hoping to buy back when liquidity returns after the holidays – a sustained economic upswing into 2022 remains firmly embedded in medium-term investment outlooks.

Powell turns into Scrooge – with unfortunate timing
The financial commentariat loves a good change of narrative. That is what they got from Fed Chair Jay Powell’s speech last Tuesday, when he appeared to reverse course in dramatic fashion. Powell had spent much of 2021 preparing financial markets for a slight reduction in asset purchases, offering reassurance that zero interest rates were not going anywhere and that inflation was merely “transitory”. But now that US inflation has hit its highest level in 30 years, there is no more Mr Nice Guy. The Fed Chair told US Congress that bond-buying could be tapered quicker than expected to combat rising prices and that the central bank should retire the “t” word when describing inflation. It was his most hawkish-sounding speech since the start of the pandemic, and it gave news outlets a juicy narrative shift: after months of mollycoddling, Powell the disciplinarian is here.

But a closer look at Powell’s language tells a different story. Powell told Congress that “It’s probably a good time to retire that word and try to explain more clearly what we mean”. The need for clarity comes from markets’ tendency to interpret transitory as meaning ‘no big deal’ – implying the central bank can simply ignore it. That was never the case, and highlighting this misinterpretation does not necessarily mean the outlook of policymakers has changed significantly. Similarly, while the bond market response implied investors expect interest rate rises to come sooner, Powell made no such assertion. Nevertheless, capital markets interpreted Powell’s comments as decidedly hawkish. Markets brought forward their expectations on Fed rate hikes – as the rise in yields on short term government bonds informs us – while longer-term bond yields fell, indicating slower growth expectations down the line. The latter may also have been prompted by fears over the Omicron variant and its potentially negative effect on the global economy.

For markets, one of the biggest concerns is that these moves could cause overall liquidity to dry up as we head into an already difficult winter. A tighter Fed means less money around, while an Omicron-induced economic slowdown increases risks and drives up financing costs. Over the longer-term, though, the Fed might rightfully feel it had to tighten things. There indeed was too much liquidity in the system, and some had to be drained out. If the Fed does not mop up liquidity, and leaves it in the market, this can create serious problems, as it drives down the returns of short-term money market funds to zero or negative – causing funds to flow out and money markets to seize up. Earlier in the year, the Fed tried to solve this problem by raising repo rates in money markets – a recognition that they had flooded the financial system with more liquidity than it could handle, or indeed was required.

So, arguably, this was a case of the right direction of travel, but setting off with unfortunate timing – Powell’s address to Congress coincided with the chaos being caused by news of the Omicron variant. From here, much depends on the economic news-flow and the fate of Joe Biden’s fiscal plans. As we go into the year-end, we suspect that will become the bigger narrative.

Turkey becomes the poster child for emerging market risks
According to Turkey’s President Erdogan, his country is at war. Exactly who or what Turkey is fighting against is unclear – this war is not a physical one but an economic one, waged against an array of foreign “opportunists”, “doomsayers” and “global financial acrobats”. Judging from capital market moves, the war is not going very well. The Turkish lira has lost around 25% of its value against the US dollar in the last couple of weeks. Year-to-date, the decline is approaching 50% and shows little sign of slowing. For currency traders, things are as bad, or worse, than the crisis of 2018. Meanwhile, inflation continues to soar – with prices rising 20% year-on-year in October. In a country that relies heavily on foreign imports, many economists worry Turkey is entering into a dangerous spiral of hyperinflation.

Currency markets’ lack of faith in the Turkish lira stems less from the economic backdrop than Erdogan himself. Turkey’s long slide toward authoritarianism has been well-documented in the western press, and Erdogan’s strong-arm tactics have often been at odds with investor preference for stability. But the biggest concerns have come from Erdogan’s unorthodox economic views. He believes that, for emerging markets like Turkey with large dollar-denominated debts and current account deficits, interest rate hikes increase inflation pressures. Erdogan has repeatedly pushed his central bank for interest rate cuts to combat rising prices – a belief he triumphantly reiterated after he praised the recent rate cut.

Erdogan’s combative style is a red flag, not just for Turkey, but for emerging markets (EM) more generally. On the face of it, 2021 should have been a good year for EM assets – with global growth recovering strongly and various commodities seeing strong gains. But some EM currencies have performed badly, against a backdrop of expected monetary tightening from the US. This has led to global capital flowing out of developing countries at a time when they need it most. EMs with high debt have struggled recently, and are at risk should global sentiment takes another downturn.

Erdogan’s strong-man politics are an extreme example of a traditional EM scare story. But interventionism and delicate politics are a common feature in EMs, from Russia to Brazil and even China. Most developing countries also have far less access to vaccines and are therefore seen as more susceptible to COVID outbreaks and the resulting slowdown in economic activity. Meanwhile, international bodies like the International Monetary Fund (IMF) have suggested EM countries are much less able to take on debt as developed countries have done – limiting the space to spend their way out of crises. With this backdrop, it does not take much to dampen investor sentiment. A currency crisis and erratic policy in one country can therefore have a big knock-on effect for financing elsewhere.

Erdogan has ruled out resorting to external funding that would tie the country to foreign diktats (something the IMF has been criticised for, down the years). In any case, the IMF would be unlikely to help Turkey without its government returning to something like economic orthodoxy – making any compromise nigh-on impossible. Ultimately, external currency problems will persist as long as Erdogan wages his war. If he is seen to be losing it – as the recent hit to living standards suggests – his own position could come under pressure.