Slower, higher, longer monetary tightening

Chief Investment Officer's team
07 November 2022
Slower higher longer monetary tightening
The US Fed hiked interest rates by 75 basis points as expected last week but delivered a hawkish message


  • The US Fed hiked interest rates by 75 basis points as expected last week but delivered a hawkish message
  • The pace of tightening will slow but to reach a higher terminal rate and stay there probably longer
  • Markets instantly fell, but recovered later with signs of slowdown in the US economy

Another eventful week just ended. The US Federal Reserve held their crucial policy meeting, and if the decision was widely expected, with another jumbo +75 basis points interest rates, chairman Powell’s message during the press conference was undoubtedly hawkish. While he acknowledged that the pace of interest rates will slow “at the next meeting or the following”, he also warned that the terminal rate needed to fight inflation will certainly be higher than initially thought. He also confirmed that no rate cuts will happen before inflation is convincingly back on track. This killed hopes from previous weeks for a softening in the tone and in the intention, in a painful wake-up call, especially as the official statement mentioned for the first-time the lag between tightening policy and its economic impact.

Coincidentally, the week was also rich in terms of economic data. Leading indicators were disappointing in China, and Europe confirmed a difficult situation with a slowdown in activity but no relief on inflation, as the CPI came out higher than expected. Coming to the US, the ISM manufacturing was modestly better than expected, just above the contraction level at 50.4. Services however came out below expectations. Bad news for the economy are good news for markets, and this was only confirmed Friday with less jobs being created in October than the median forecast.

Weekly returns remained overall negative, but it could have been worse, especially as Chinese stock markets had a strong rebound, which we believe is more linked to excessive pessimism than to actual catalysts. Volatility remains the name of the game, and the change in regime we are all hoping for may also take longer and be slower than initially thought. Stay safe.

Cross-asset Update

It was a negative week for US equities in the wake of the hawkish message delivered by the Fed at the November policy meeting, yet the major stock markets closed in positive territory and some cross-asset relationships remain at odds with general negative investor sentiment. Going by the numbers, heavyweight technology stocks led the bulk of the US benchmark losses, with the Nasdaq down 5.7%, but deep cyclicals like industrials and materials were up in the five days through Friday, hence driving the outperformance of the Dow Industrials, that lost 1.4%. Non-US markets actually put in quite some gains, as Europe gained 1.5%, and the UK 4%, although the BOE raised its benchmark rate, and the MSCI EM index rose by 4.7%, on rumours of China reopening. Gold ended 2.2% higher, in spite of Powell’s message, while The US dollar index was little changed for the week, but slumped on Friday following a jobs report starting to show some cracks in the US labor market. Overall it seems that, barring the fall in technology suffering from the fallout from a disappointing earnings season and heightening the general level of volatility, intermarket relationships did not paint such a dire picture.

Across earnings, rates and macros, no obvious positive trigger comes to mind, if not the possibility that the Chinese authorities ease Covid restrictions and open the economy. Although the health authorities have reiterated that zero-covid policies will be unswervingly adhered to, some market pockets are trading as if this is true, with both global industrials and materials, and Europe, most exposed to China, in positive territory in the five days through Friday. Also, EM CDS spreads peaked in July and have since inflected lower, alongside more comprehensive measures like the Citigroup EM Macro Risk Index. Such an event initially would undoubtedly boost global growth in a non-inflationary way, unclogging the transmission channel of the expansive credit policies that to-date have had little impact in China due to the existing restrictions. Second-round effects would be less welcome, as growing commodity demand would be contributing to inflation and give even more headaches to DM central banks. The reopening trade may breathe some life in EM equities, so oversold that any positive news flow can trigger a rebound.

Interestingly, gold failed to make new lows for the year following Powell’s hawkish turn, and actually closed above the previous two weeks’ highs on Friday. Markets for the time being could be betting on a shorter monetary cycle, a cycle investors are all too eager to look through. Could it be that the Fed hikes 75bps in December, downshifts to 50 in January and then it is done? Maybe, so that they rapidly reach their target rate, not incurring the mistake of having to revert to larger hikes if inflation surprises to the upside. We do not know whether a Fed funds level around 5% will be actually enough to quash inflation, but meantime gold can rally, as investors chase the end of the monetary cycle in their minds.

Fixed Income Update

The FOMC rate decision did not shock anyone, but Powell's press conference did the trick. The previous week's bullish sentiment was driven by expectations of a 50bps move in December and dovish muttering from the non-Fed central banks. However, the declaration that the Fed will need to hike rates more than anticipated in the Dot Plot, pushing back against any notions of premature pauses, and confirming that the Fed is ok to deal with conditions arising from overtightening rather than let go of inflation, affected sentiment negatively. Moreover, markets realized that moving to a lower gear doesn't mean a pivot or end of the cycle, particularly as the NFP data showed last Friday that the labour market remains strong.

The front-end yields rose, and the curve flattened, unwinding the previous week's moves and more. The 1 and 2-year yields are now close to 4.7%. The 10-year yields hover around 4.17%. The 2s10s part of the curve had deepened its inversion while the 3m10y part is close to inversion. All of this points towards a challenging 2023 for risky segments in the fixed income. BoE followed with a 75 bps rate increase but a dovish tone by Governor Bailey. The Governor firmly pushed back against market expectations for the scale of future increases, warning that following that path would induce a two-year recession. This sets the Fed apart from the other two big central banks, ECB and BoE. The ECB had earlier provided some assurance to the analysts after the 75 bps hike last week, which was considered dovish.

High Yield was surprisingly resilient in the face of such hawkish onslaughts. Supply also remains light and is down 78% YoY, earnings are better than expected, and the retail mutual fund base reported its largest inflows ($4.28bn) in 14 weeks, according to a JPM report. As the Bloomberg Barclays index shows, the U.S. High yield bond yields increased 25bp, and spreads decreased 3bp over the past week to 9.38% and 462bp, respectively. The 25-year average default rate for BB, B, and CCC-rated bonds is 0.7%, 2.6%, and 6.7%, respectively, compared to implied default rates based on current spreads of 0.1%, 2.2%, and 7.7%. The average default rate for BB, B, and CCCs in a recession is about 2%, 7%, and 14%, respectively.

The U.S. distress ratio, the proportion of speculative-grade (rated 'BB+' or lower) issues with option-adjusted spreads of more than 1,000 basis points (bps) relative to U.S. Treasury, increased to 7.6% as of Oct. 17, from 6.6% as of Sept. 22, 2022, according to S&P. As movements in distress, the ratio can run roughly parallel to movements in the U.S. default rate (with several months lead time). S&P believes the U.S. trailing-12-month speculative-grade default rate will rise to 3.5% by June 2023 from its current levels of 1.6% in case of a shallow recession.

Equity Update

Emerging markets rallied last week with China equities gaining 11%, including a corresponding rally in the Hang Seng index and the Golden Dragon China Index (China companies listed in the US). Other EM too had a good week i.e. LATAM, India and the UAE. On the Developed Market front the US had a down week as the Fed delivered a hawkish message and the strong labour market was seen as a trigger for continued Fed rate hikes. Midterm election results should impact the market only if vastly different from expectations. Europe and Japan had a positive week and the US was the outlier amongst global market performance.

Whilst reopening news on China remains mixed, we expect a pick up from oversold levels for equity indices with the MSCI China trading at 10.3X forward Price to Earnings. We have remained neutral EM Asia (including China) the last few months and would stay with that view. However, having held China equities through the selloff investors should get benefits of near term upside. From a strategic and even more fundamentally driven tactical call we continue our preference for India and the UAE. We may see smaller gains into year end, but India remains a growth story and equity performance continues to be driven by growing consumer demand, inflation that is not too far away from Central bank targets, hence some stability on rate hikes. The UAE remains a dividend play and one of the few markets globally attracting investments into new listings. Capital comes at a premium when rates rise as seen by the limited off take recently in venture capital raisings in Silicon Valley. Tourist inflows into the UAE on the back of the Qatar World Cup will enhance the service sector growth and are a good diversifier to oil revenues. This year Hotel Rev Pars (average Room Rates) are already up in spite of the AED peg to the strong USD.

The Nasdaq 100 had the second biggest weekly drop this year, back to mid-2020 levels, as technology stocks fell in reaction to the Fed message on raising interest rates further to tame inflation. Performance of longer duration growth stocks, like tech, are based on expected future earnings, which are devalued when interest rates rise. Also Big Tech earnings have exhibited weakness this quarter. Semiconductor companies’ guidance point to a slowing growth outlook, with Qualcomm, a leading mobile-phone chip supplier, reducing smartphone shipment forecasts in line with Apple lowering forecast for shipments as its China factory faces lockdowns. Advanced Micro Devices sees lower revenues and Intel ongoing cost cutting and layoffs. Amazon is pausing hiring. Facebook has guided on lower digital ad revenue and Amazon, Google and Microsoft on cloud services growth slowing. Large job cuts at Twitter under the new leadership of Elon Musk add to the tech malaise. Currently financials and energy (both traditional oil producers and clean energy such as hydrogen) provide a better risk reward outlook. Bank profits whilst affected by slowing credit and consumer defaults should be offset by the higher rates impact on Net interest margins. Banks with higher CASA will benefit the most such as the UAE. Oil companies have record profits this year and are investing in greener initiatives, diversifying their income streams. Both sectors are also strong dividend payers.

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