What an extraordinary start to the year. Last week saw a much-needed rally in equities. But that was only after a big fall on Monday and a last minute rally in US equities on Friday. And it occurred despite a hawkish press conference by US Federal Reserve Chair Jay Powell as well as generally weaker economic data.
What is going on? There’s no doubt that the new found aggressive messaging from the Federal Reserve is worrying the markets. But that is now priced in. The Federal Reserve will stop it’s QE programme in March and begin a programme of raising the Federal funds rate. The markets now expect four increases this year. Just a few months ago, the consensus was that there would be no increase at all in 2022.
Markets give Fed credit for action
The reason for the Fed’s new rhetoric is inflation of course, which has risen further and faster than the Federal Reserve expected. Moreover, the source of inflation has moved beyond items like auto prices, that could reasonably be described as transitory, to rents and wages, which are more enduring. So, the Fed have got the message and the markets have given them credit for acting, demonstrated by longer-term breakeven inflation rates remaining low and steady, despite the current surge in inflation.
There has been an interesting pattern of weaker data in response to the Omicron variant. In Northern Europe, which imposed the most severe restrictions, economic data has not been as bad as expected, but in the worse cases it’s been worse than expected. It seems that consumers are taking matters into their own hands and were hesitant in England and the US despite the absences of tighter government restrictions.
Either way, consumers are likely to spend more in the coming months despite the real income squeeze from higher energy prices. The Omicron variant is proving to be much less troublesome than feared, less severe than Delta and previous variants. Europe is dismantling its restrictions and only China is continuing to take tough steps, something that will be highlighted by extraordinary restrictions around the Winter Olympics.
Spending on the up in developed markets
Households may face a squeeze on their current incomes but in developed markets at least, consumers have a big pot of unspent cash sitting around as a results of generous fiscal handouts in the last couple of years as well as the fact that they have been unwilling or unable to spend during the pandemic. This amounts to around 11% of incomes in the Eurozone, 13% in the UK and 14% in the US. Even if only part of this is spent in 2022, consumer spending will be strong. And corporates are spending too. Capex orders are booming in the US and are strong in much of the rest of the developed markets.
Higher spending means higher corporate earnings. The current reporting season is delivering significant beats on both earnings and revenues in the US. Admittedly, the market’s attention is elsewhere at present but once the excitement on US monetary policy dies down, we expect the positive prospect for earnings to provide support for risk assets.
This week holds key data for the US and key decisions for the UK
It’s a big week for data with US employment out on Friday. The markets expect a small increase, due to concerns over Omicron and it’s even possible that it turns out negative. But this would be a one-off, longer term we expect US employment to grow strongly.
It’s a big week in the UK too, with the Bank of England likely to raise base rates to 0.5% and present a potentially gloomy prospect for the UK economy with high inflation and paltry growth. And with base rates at 0.5% the Bank will start to let its huge stock of gilts run down, switching from being a massive buyer of gilts to a massive seller. The change in the supply/demand balance could send yields higher.
Meanwhile, over in Europe, an inflation scare is just getting going. German and Spanish inflation numbers for January have just come out and the numbers are way higher than expected. It seems that European companies are starting the year with big price hikes. Will the European Central Bank (ECB) take notice? We shall see, but if serious talk of rate rises by the ECB takes hold, it would be a major development.
Equities settle but bonds set for more volatility
So, after a wobbly start to the year, equites have settled down for now. Longer term, they look likely to continue to rally. The headwinds from higher interest rates means that we cannot expect strong gains but we still think the bull market is intact. Bonds by contrast look set to have a torrid time.
Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.
The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.