It’s been a tough week for equities as bond yields rose sharply. Just a few weeks ago, the US Federal Reserve was describing inflation as transitory and insisting that they would keep policy easy. But shortly after he was reappointed, the Chair of the Federal Reserve, Jerome Powell, retired the word transitory, and the Fed’s rhetoric has become increasingly hawkish. Last week’s minutes revealed that the committee had even discussed quantitative tightening – running down their stock of bond purchases.
Investors get realistic about monetary policy
So, the market is now pricing in the first rate hike in March with several increases to follow. For the first time in months, we believe that the Federal Reserve and the market have a realistic assessment of the prospects for monetary tightening. In that sense, the headwind from higher yields is priced into the market.
Omicron fears recede but there are still headwinds
At the same time, fears that Omicron would halt the global economic recovery have been assuaged. Yes, Omicron is much more transmissible that other variants, but it is also less severe. So hospitalisations are much less. In addition, new anti-viral drugs should further reduce the risk of severe illness for the most vulnerable. All this suggests that the world will live with Covid, and that the recent restrictions imposed in Northern Europe should not need to be repeated.
The Omicron scare has had its impact though. We think that unemployment will increase in the UK and there will be further weak economic data in Europe. Retail sales probably fell in December in the US too.
Consumers and companies are cash-rich and supply disruptions are easing
But these effects are temporary, and growth should reaccelerate as spring approaches. Consumer finances are healthy and although fiscal policy is tightening in the UK and US, they have plenty of cash in the bank, unspent from previous fiscal support. Moreover, companies have plenty of cash too and are boosting spending on capital expenditure, dividends and share buybacks. There are clear signs that supply disruptions are easing with a jump in semiconductor production in Asia and supplier delivery times improving in recent surveys. That bodes well for production increases in the coming months.
With yields heading higher, equities can’t be expected to deliver the strong returns enjoyed last year but they still look likely to beat cash and bonds – at least in developed markets.
China and emerging markets continue to struggle
Emerging markets face a tougher environment. China is due to host the Winter Olympics and is closing down polluting industry in a wide radius. Their zero tolerance policy towards Covid may also weaken the economy, especially if it extends to the lunar new year. Other emerging markets may struggle in the face of higher US interest rates.
Later this week the US earnings reporting season kicks off. Financials report first and their results should be strong. We will be watching other sectors very closely for any signs that margins are being squeezed.
So, we expect the choppy waters for equities to persist in the near term, but looking further out, risk assets still look set to outperform.
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