Monday digest

Posted 7 February 2022

Overview: Confusing short-term outlook makes for messy market action

After a disappointing January for investors, February made a promising start, only to revert to the same wild trading pattern towards the end of the week. Nevertheless, what unnerved markets last Thursday and Friday followed the same playbook as the market turbulence in January: central banks choosing to no longer ignore inflation pressures and markets reckoning with the idea that the growth slowdown is slowly morphing into a growth slump.

Clearly investors are concerned central banks are pivoting towards monetary tightening exactly at the point when the economy is at risk of slowing further, sliding from a slowdown in growth that started after last year’s activity bounce-back into a more serious growth shock. Should the central banks stick to their guns as growth turns negative this would clearly be seen as constituting a central bank error – historically the most common reason for economic recession. Market nervousness is therefore understandable, given the economic outlook has become far hazier than it was a year ago as the cycle has gone from its ‘early’ to ‘mid-cycle’ phase. Moreover, investors have no experience with post-global-pandemic recoveries to ground them, which only increases the level of uncertainty and insecurity.

Central bankers recall the wage-price-inflation spiral dynamics of the 1970s, and are therefore doubly alert to the potential dangers we are now facing. However, warning from history does not apply to the average consumer, and neither do we still have widespread collective wage bargaining structures that encourage blanket wage hikes. Here at Tatton, while we cannot be entirely certain, we expect that the loud noises from central banks – together with the cacophony of the coming price shock or price-of-living-crisis – will see consumers tread more carefully with their spending plans, rather than all at once resigning from their jobs in pursuit of higher pay.

We remain optimistic for portfolio investors for 2022 overall, although we admit that the economic outlook for the first quarter of the year is no longer looking positive. The shock to disposable consumer incomes from energy price rises is going to have a knock-on effect on corporate earnings, which may slow companies’ willingness to invest and spend. Interestingly, this dynamic makes aggressive central bank tightening action much less likely, as the job of curtailing demand to dampen demand-driven inflation pressure is taken out of their hands before they are forced to act.

Spring still feels a long way away, and the next few weeks may continue to be both unnerving and somewhat unstable in capital markets. For now, all signs from the global economy point towards a blip, rather than a cycle-ending downturn. We have been in these situations before, and capital markets have tended to ‘look-through’ such periods when there were enough signs that the slowdown would ultimately prove temporary.

UK leads the monetary tightening charge
Last week policymakers revealed their hand. European Central Bank (ECB) President Christine Lagarde (finally) declared that inflationary pressures had to be countered with a change in monetary policy towards a gradual tightening – not immediately, but in due course. This followed the medicine prescribed by both the US Federal Reserve (Fed) and the Bank of England (BoE), and means that all major central banks, bar the People’s Bank of China, have now pivoted from an easing to a tightening stance – even if only the BoE has raised rates so far. That decision was announced last Thursday, with Governor Andrew Bailey announcing the decision to raise interest rates by 0.25% to 0.5%. This marked the BoE’s first back-to-back rate hikes since 2004, and officials do not plan on stopping there.

While the BoE looks to fight inflation head-on, the Treasury will tend to the wounded. To offset the cost-of-living crisis hitting households, Chancellor Rishi Sunak promised £9 billion toward energy prices, including a £200 government financed electricity ‘discount’ (repayable over four years) and a £150 council tax rebate for 80% of English homes. It is hard to separate the government’s fiscal support from the current political context. An under-siege government, and increasingly isolated-looking Prime Minister, will want visibility in easing the cost-of-living crisis, so we should not be surprised if further measures are announced in the coming weeks or months. However, the Treasury’s difficulty is balancing the need to ease the income squeeze with the need to minimise inflation pressures.

Both the Bank and the Treasury recognise that monetary and fiscal policy must work together in the face of Britain’s biggest price shock in decades. The Chancellor’s planned increases to tax and National Insurance will come into effect at the same time, just when the BoE expects overall inflation to reach 7.25% year-on-year. This cocktail of price rises will result in the biggest disposable income squeeze in decades. In terms of the wider economy, the BoE expects the disposable income squeeze to bring down soaring inflation eventually – but it will most likely also slow growth down to an annual 1% by 2024 in the process.

Supply chain disruption has now continued for so long that inflation expectations have become embedded in the economy – leading to higher wage demands and fears of spiralling inflation. The BoE is desperate to prevent this spiral, but the uncomfortable truth is that – without a dramatic increase in global supply – this requires at least some level of demand destruction. That is precisely what rapid rate rises are designed to do. The Treasury’s job in this is pain management – allowing some demand destruction while easing the pressure on the worst-off and avoiding long-term scarring for many parts of the economy. ‘Partygate’ aside, this process is what the government will be judged most for in the medium term, and politicians can expect considerable scrutiny after recent events.

Tech stocks brought back to (virtual) reality
The last two years have been good to America’s technology giants, but last week’s market action had a ring of ‘the bigger they are, the harder they fall’. Meta, formerly known as Facebook, plunged 25% in stock market trading on Wednesday afternoon. Chief executive Mark Zuckerberg warned investors that the current quarter would probably be Meta’s worst on record, prompted by competition from TikTok and a prolonged slowdown in user growth – culminating in the first-ever drop in active users. The plunge in value meant $200 billion was knocked off the company’s market capitalisation in a single trading session – the most any company has lost in one sitting.

Investors’ visceral reaction to Meta’s woes was astounding, but the eye-watering drop is about much more than background conditions. Both last quarter’s earnings and the future guidance came in below expectations. Thanks to the popularity of TikTok’s short-video format, Facebook now looks behind the curve of social media trends, while changes to Apple’s privacy rules threaten the core of its advertising model. Meta is facing its own specific problems, but they speak to wider trends for big tech. Online platforms were boosted by the pandemic’s stay-at-home orders, but as populations emerge from lockdown, habits are clearly changing. Streaming service Netflix released disappointing data on new subscribers a few weeks ago, and was promptly punished by stock traders. Markets are also likely reacting to a shifting medium and long-term picture. Over the last two decades, social media has grown from a fringe novelty to a ubiquitous part of work and social life. As platforms reach saturation, growth inevitably slows down. Facebook and similar platforms have arguably entered this saturation phase. That does not mean it will go the way of Myspace, but it brings a change of business model, and therefore a change in the way it is valued. Investors might now view Meta as a utilities (like) company – one with reliable cashflow, but less potential for growth.

The struggles of Netflix and Meta show specific signs that fortunes are changing. These may have been less of a problem for investors while markets were awash with liquidity. Now that money is expected to be harder to come by, investors are re-evaluating tech’s prospects. This is far from the end for them, but it may well force the pandemic’s ‘big winners’ to adapt to the post-pandemic world.

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