Monday digest
Posted 31 January 2022
Overview: Fears of ‘taper tantrum 2.0’ rattle markets
The unnerving start to the year escalated last week, with many lay observers attributing market volatility to the rising possibility of war between Russia and Ukraine. But while geopolitical tensions are not helping markets (nor energy prices), the heart of the market rout lays with central bank efforts to fight inflation through monetary tightening.
Readers may be reminded of the 2013 ‘Taper Tantrum’, when equities sold off heavily after the Fed announced intentions to wind-down its quantitative easing (QE) policy by reducing the pace of US Treasury purchases – indicating the beginning of a monetary tightening cycle. Back then, the news caused a ‘tantum’ from bondholders, pushing up bond yields significantly, while equity markets recovered relatively quickly. This time, of course, we are in near-uncharted territory (a post-pandemic recovery period), while central banks have not entered a tightening cycle intended to bring down inflation since the 1990s. Markets are, therefore, excused for being both jittery and confused about the most likely direction of travel, as last week’s wild market swings evidenced. That there were almost as many buyers as sellers of risk assets this week points to certain cohorts of investors being willing to identify positives further ahead, and also willing to assume the Fed will resist being too single-minded in its inflation fight to inadvertently choke off the nascent recovery.
Hawkish Fed hovers and circles
That last week was another wild ride in capital markets was in no small part thanks to the US Federal Reserve (Fed). The volatility culminated in a dramatic market sell-off on Wednesday afternoon, after Chair Jay Powell used the Fed’s post-meeting press conference to broadcast his most hawkish message in years. Powell all but confirmed the Fed would raise interest rates in March, and did not rule out a more aggressive tightening schedule than markets were expecting already for this year. Three quarter-percentage point hikes are pencilled in for this year, but the Federal Open Markets Committee (FOMC) is open to more if needed. Powell even suggested this could start with a 0.5% hike in March, noting that labour market conditions are tight, and inflation is dangerously above target. FOMC members also extensively discussed how to shrink the Fed’s $9 trillion balance sheet, laying out a set of principles for starting the process.
On Powell’s reckoning, supply pressures will remain until 2023. Historically, that’s quite a prolonged period of inflation pressure that threatens to embed inflation in people’s mindsets, thereby justifying the Fed now choosing to put the fight against inflation top of its agenda. Officials can take this harsher approach, according to Powell, because of the strength of the US economy. Despite weaker recent signals, growth is still running above trend and the economy is stronger now than when the Fed last started a tightening cycle in 2015. What’s more, US unemployment dropped to 3.9% in December, the lowest rate since the pandemic began and consistent with the FOMC’s goal of “maximum employment”. These factors mean “there’s quite a bit of room to raise interest rates without threatening the labour market,” according to Powell.
In our opinion, that assessment sits uncomfortably with some of the latest data releases. Strong growth, soaring prices and labour market tightness were very visible last year, but have all arguably peaked. Although GDP data for the last three months of 2021 proved ostensibly stronger than expected, US final demand growth appears to have eased in the latter stages of the year. Moving into 2022, it seems to have eased further, while supply chain pressures also seem to be easing, according to the Fed’s own measures. The strong growth and high inflation we saw last year was a combination of rebounding demand and constrained supply, compounded by the so-called ‘great resignation’ of workers not coming back to their jobs post-COVID. However, the most recent indicators of consumer confidence have weakened considerably, which is usually a sign of slower demand ahead.
For global investors, the main upside is that this appears to be primarily a US problem. For all the talk of energy shortages and bottlenecks in Europe, it is American (and to a lesser extent, British) consumers who have been hit hardest by the disposable income shock. There are many reasons to be positive about growth over the medium term. But there is no doubt that we have seen a significant weakening of the short-term picture recently. In order to stop the slide in consumer confidence spilling over into business confidence, the Fed may have to adjust perceptions of hawkishness sooner rather than later. It is difficult to imagine Powell turning the screw further should data continue to weaken, but it is also possible that should inflation remain elevated, the Fed may be willing to risk more of a tantrum from markets than allowing the inflation genie back out of the bottle.
Is looser policy from Beijing more than just window dressing?
Ever since property developer Evergrande began missing debt payments in September, the Chinese government seems to have been operating a controlled demolition. Once a symbol of China’s growth and rapidly developing middle class, Evergrande has been allowed to fail by Beijing, provided its woes do not spiral into wider contagion. That is a risky strategy, considering the company’s size and the fact that China’s property market accounts for a quarter of its economy. But Chinese authorities are reportedly considering a proposal to dismantle the Evergrande group by selling off the bulk of its assets – seemingly in an attempt to draw a line under the crisis.
Beijing’s approach to Evergrande is emblematic of its wider economic management. Deleveraging China’s sizable private debt load has been a top government priority for years, and officials have pushed ahead with their attempt even when economic growth has been threatened. We saw this throughout the pandemic – while most major economies loosened monetary and fiscal conditions, China tightened policy and cracked down harshly on swathes of the private economy. This show of brute strength had a big impact on growth in the world’s second-largest economy. China expanded strongly in the early part of last year’s global recovery, but like many other major economies, momentum slowed toward the end of the year. The situation was compounded by Beijing’s ‘zero-COVID’ policy which, despite high vaccination rates, has seen entire regions submit to harsh lockdown measures as the omicron variant spreads.
However, recent weakness seems to have pushed the government to reconsider its policy. The People’s Bank of China (PBoC) has cut interest rates and bank reserve requirements in a bid to stimulate demand. Recently, it pledged to open its monetary toolbox and use its lesser-known tools to boost credit expansion. Curiously, this leaves us in a reverse of the situation earlier in the pandemic. As the Fed tightens US monetary policy, China is moving the other way. While this is unlikely to result in an all-guns-blazing approach, it should cushion China’s current slowdown and maintain the economy’s impressive (in absolute terms) growth rate. On that point, it is worth noting China has experienced significantly less inflation pressure than elsewhere, while still benefitting from last year’s broad global rebound. Chinese consumers have therefore not had the same hit to real disposable incomes as those in the west, meaning the starting point for demand is healthier. These factors have turned many major investment banks positive on Chinese equities this year. This is perhaps a controversial play, considering the backdrop of weakening growth, property sector woes and a government fond of crackdowns. There is also a strong possibility that Beijing could reverse its stance if debt fears continue, and some have suggested its policy changes are just economic window dressing ahead of the upcoming Winter Olympics.
We think the move toward stimulus is genuine, even if it is going to be the ‘new’ Chinese way of doing things – all in moderation. Cleaning up an entire sector will see its losers and winners, but is a necessity. At the same time, those who dare stand the most to gain if they buy before the dawn, when the picture still looks dark. The recent news on Evergrande suggests officials want to put these problems behind them. And while Beijing has hitherto dragged its feet on the stimulus front, the signs this year look more positive.