November Investment Summary
“The economy is very strong and inflationary pressures are high, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases… perhaps a few months sooner,” US Federal Reserve Chairman Powell said at his appearance before the US Senate Banking Committee on November 30. He also admitted that it was time to retire the use of the word transitory when referring to inflation. “It’s probably a good time to retire that word and explain more clearly what we mean,” he said.
Mr. Powell’s remarks combined with the discovery of the Omicron variant of Covid-19 was enough to cause a late month swoon in global equity markets. The appearance of the Omicron variant in Europe, right after its discovery in South Africa, produced sharp falls in European equity markets of between 2-4% for the month as lock downs were announced or contemplated by government authorities. Japanese equities also suffered nearly a 4% drop for the month, while the US and Chinese markets were roughly flat. We also saw sharp drops in many commodity prices, particularly oil and a fierce sell off in crypto assets as well.
Well, what do they (the Federal Reserve) mean? We suspect they are finally acknowledging what we are all experiencing: economies running hot on the back of massive fiscal stimulus and still exceptionally generous monetary policy that is producing higher inflation than we have seen in some time.
This generous monetary policy, via a combination of very low (even negative) interest rates and the massive asset purchase programmes of government debt has clearly been a driver of asset price inflation, but given these tools have been used by central banks for the best part of a decade, what else is driving inflation higher? Pandemic induced supply chain disruptions have clearly had an impact, whilst a shift in consumer spending habits with households favouring goods over services has also contributed to the rise. Energy related issues, as drawdowns of natural gas supplies from last summer have collided with an industry that has little spare capacity and is unable to meet the demands of world activity picking up all at once, has also been a major contributor. The rise in average hourly earnings, driven by an increase in labour demand as economic activity recovered, has also contributed to the spike in inflation. Taking all of the above into consideration, you start to envisage a scenario where inflation could be persistent for a longer period than first anticipated in early summer.
What will central banks do to manage this outcome? Our expectation is that they will be slow and cautious about removing monetary accommodation given the potential impact on asset prices. The Fed has already begun to reduce the size of their monthly asset purchases, which have been running at a staggering $120 billion per month during the pandemic. It appears they will end these purchases by late spring setting the stage for a few rate hikes. The Bank of England has suggested they will hike rates first and then end their asset purchases while the ECB has no plans to do anything just yet. China has begun to ease monetary policy as they are trying to manage their heavily levered housing industry, which is struggling. It would not be surprising to see the Fed funds rate in the US at 50 to 75 basis points by the end of next year and UK base rates at 1%. The ECB may even see rates as high as zero! None of these moves should halt the equity bull market or seriously impair growth. However, this shift away from super accommodative policy will unnerve markets as we have just experienced, so we would expect higher volatility ahead in financial markets.
We still favour equites but would recommend overweighting firms that make a profit and have pricing power. Companies with unusually high valuations that lack earnings are vulnerable to sharp re-ratings by the markets. Crypto assets are also vulnerable to sudden swings in sentiment. Looking at the NY FANG index and Bitcoin show a remarkable correlation, indicating that crypto is not quite the diversifier that investors would like to believe.
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