The all-important Fed meeting came and went last week with global markets largely taking the more hawkish than expected tilt in their stride. Global equities retreated modestly, but bond yields actually fell over the week – with the latter perhaps still more concerned with the rapidly spreading Omicron variant.
The key news last week was the Fed effectively pencilling in three rate rises next year, compared to market expectations of only two. The Fed did accelerate bond tapering as widely expected, with the program now scheduled in March – which should pave the way for the first rate rise in May. The Fed have also pencilled in three further rate rises in 2023 – which all up means the mid-point of the Fed target rate range would rise from 0.1% at present, to 0.9% at end’ 22 and 1.6% at end ’23.
By my reckoning, U.S. 10-year bond yields under this scenario should reach around 2.25% by mid-22, compared to only 1.4% presently. If the U.S. S&P 500 forward PE ratio held steady around 20, it would imply a decline in the equity risk premium (or forward earnings yield less bond yield gap) from 3.4% to to 2.75% – or the low end of its range since the global financial crisis over a decade ago. Indeed, this yield gap was last seen in turbulent 2018, when sustained Fed tightening over several years had finally pushed 10-year bond yields over 3% and produced a decent correction in equity prices (the S&P 500’s PE ratio fell from 18 to 14 over the year even whilst forward earnings kept rising). Will history repeat itself? I suspect the odds of a decent equity correction – of at least 10% – are greater than 50%.
In other news, the Bank of England surprised markets by electing to hike rates – even as Omicron courses through the UK economy – due to a desire to ensure currently high annual core inflation of 4% is not embedded into expectations next year. The European Central Bank equivocated – pledging to end one bond buying program early next year while promising to keep buying under another program. Like the RBA, the ECB still thinks it won’t raise rates next year.
The key global highlight this week will be the Fed’s preferred inflation measure, the private consumption expenditure (PCE) deflator on Thursday. This is expected to show a further uncomfortable lift in core annual CPE inflation to 4.5% from 4.1%
Despite lower bond yields, last week’s Fed pivot saw value stocks outperform growth, with this trend potentially likely to gather steam in the months ahead (which in turn could also favour non-U.S. developed markets like Europe and Japan – though the latter has the handicap of being more likely to go back into lockdown if Omicron cases explode).
Emerging markets remain on the nose, and higher U.S. rates only seem likely to aggravate this situation. Australian relative performance has become more choppy in recent weeks.
The local equity market continued to meander sideways last week. Within the market, recent moves by China to ease credit conditions have helped resources companies regain relative performance in recent weeks, while the technology sector has weakened in the face of both renewed regulatory scrutiny of the buy-now-pay-later (BNPL) sector and the Fed-induced rout of growth/technology stocks globally. RBA Governor Lowe indicated in a speech that the Bank will review its bond buying program at the February meeting. My call is the RBA will simply end the program in its entirety at that meeting, especially if the late January Q4 CPI shows another higher than expected result.
The key local highlight last week was the blockbuster November labour market report on Thursday, which revealed a 366k rebound in jobs following the end to lockdowns in both NSW and Victoria. The unemployment rate plummeted back to 4.6% (from 5.2%) even though labour force participation strengthened further to be back around pre-COVID levels (unlike in the U.S. where it remains well below pre-COVID levels).
Recent local and global developments make me nervous about my call the RBA won’t raise rates next year. Indeed, I’m warming to the view that the RBA may well relent and lift rates by November – even if annual wage growth has not by then accelerated to 3-3.5%. All we may need to see is a few more upside surprises in either inflation and/or wages. Thanks to very high vaccination rates, I think the economy can withstand the Omicron variant fairly well, though Omicron may lead to more inflationary global supply disruption. Anecdotes suggest local wage growth is picking up, and the return of immigration may not be quick enough to undermine local worker bargaining power!
It should be a quiet week locally, with investors focused on Omicron, the technology correction and U.S. 10-year bond yields ahead of the holiday break.