Volatility returned to financial markets this week with deepening worries over Chinese property developer Evergrande’s liquidity crunch. In the US, policymakers announced that a tapering of the Federal Reserve’s USD 120 billion-a-month asset purchase programme is on the way. This represents the biggest step towards normalising monetary policy since the Fed took unprecedented action to stave off an economic collapse at the start of the pandemic.
COVID-19 – Lingering effects
World daily new Covid-19 cases have eased mildly, but have remained high at around 510 000 per day. Infection rates in the US persist at around 140 000 a day with hospitalisation rates showing signs of easing, albeit from high levels. This trend suggests that the US may have passed the peak of infections.
Infections are trending down in most European countries, however, there is potential for a rise in infections as the school year begins. Transit mobility is picking up as people return to the workplace. It is converging towards pre-crisis levels in Italy, Spain and Germany, while mobility is picking up to above pre-crisis level in France. In the UK, it is improving, but lagging behind peers.
In Asia, the pandemic is improving in countries including Japan, Malaysia, Thailand, while others are struggling to contain the Delta wave (Vietnam, the Philippines). Singapore is facing a resurgence of cases despite 80% of population being fully vaccinated as the country has dropped its ‘zero Covid strategy’ to adopt a ‘living with Covid’ approach. The number of severe cases is low, but rising rapidly. This indicates that an 80% vaccination rate may not suffice to keep Delta from spreading.
In China, infections are rising due to an outbreak in Fujian province. Beijing has imposed a strict lockdown for 4.6 million people in the city of Xiamen as the elimination strategy remains the country’s key tactic – despite having around 70% of its population fully vaccinated.
Big or little trouble?
As expected, September has turned out to be the most volatile month for markets since the first quarter of 2021 (and October could be too). The VIX volatility index has jumped from 18 to over 23 (as at 21 September) and the S&P 500 is down by 4%. Could there be more bad news ahead?
It has become easier to come up with a list of risks facing the markets than to name potential positive catalysts. In addition to the lingering pandemic effects described above, China has returned to the fore with the potential Evergrande default.
China was already a rising concern among investors due to regulatory changes, rising coronavirus infections, reimposed restrictions, and purchasing manager indices (PMIs) falling to below 50, indicating contracting growth.
Many investors expect the authorities to respond to support growth, but Evergrande’s problems illustrate the dilemma faced by the government. Previous rounds of fiscal stimulus have led to high corporate and municipal debts. Beijing has been trying to lower debt levels (deleverage) in the economy for years, but efforts had been put on hold during the pandemic.
One factor that encouraged borrowing was the belief that any bank, property developer, municipality facing difficulties would be bailed out by the state. The government has been trying to change that attitude by allowing more and more companies to fail. The amount of Evergrande’s debt (about USD 300 billion), however, makes that outcome less likely since it could pose systemic risks to the country’s banking system. Many individual households could be directly impacted by a collapse of the developer.
We see Evergrande-specific liquidity risks as contained, but there are risks of contagion to the construction and materials supply chains, hurting commodities and social stability (construction workers and home buyers) and creating credit stress (de-risking in China high-yield bonds).
In view of the long time investors have had to adjust the Evergrande situation, liquidity risks should be limited. Moreover, Chinese banks should have enough of a buffer to absorb bad loans in the event of an Evergrande collapse. Continued buying of companies operating in areas where policy commitments are strong, such as green energy, advanced manufacturing, and mass consumption, should support the equity market.
No big surprises from the Fed
As expected, chair Jerome Powell confirmed after this week’s meeting of the Federal Open Market Committee that at the next FOMC meeting (on 2-3 November) the Fed would announce it is to begin tapering its quantitative easing programme.
Chair Powell expected the taper to be completed in the middle of 2022. This implies the Fed will buy USD 10 billion fewer US Treasuries and USD 5 billion fewer mortgage-backed securities each month from December.
Finishing by mid-2022 grants the Fed more optionality to raise interest rates. Even if it doesn’t intend to make use of that optionality – because it might not expect the economy to have met the criteria for ‘lift off’ – the existence of that optionality will be embedded in market prices.
It seems that members of the FOMC are split into two camps (see exhibit 1) over the implications of its average inflation targeting (AIT) framework for monetary policy strategy after the first rate rise.
Chair Powell’s comments on the labour market in the context of the tapering decision raise a tiny doubt (but only tiny) about whether he is in the dovish camp. Any suggestion that he is not as dovish as generally believed (i.e. one of the most dovish people at the Fed) would affect market pricing.
The Fed’s economic forecasts
Current year growth has been revised down (see table 1), with partially offsetting upward revisions to 2022 and 2023.
One potential explanation is that Fed central bankers expect the latest round of Delta-induced bottlenecks in manufacturing supply chains to be resolved by a burst of additional production next year, while foregone face-to-face consumer services spending over late-summer 2020 is simply lost forever.
Despite a slightly lower overall path for GDP, the unemployment projections for the medium term were unchanged.
The core inflation forecast has been raised for this year (to account for upward surprises in the data) and was bumped up by 10-20bp through 2022/23, which chair Powell described as a ‘very modest’ overshoot of the 2% policy target.
Taken literally, the slightly higher medium-term core inflation forecast without any change to the unemployment projections indicates the Fed has nudged up its profile for inflation expectations.
Fed’s dot plot signals different views
The FOMC was split right down the middle over whether to signal a rate increase in 2022, a theme that runs through the dot plot and becomes more pronounced in the later years.
Nine members of the FOMC now expect a US rate increase next year, according to the latest projections, with the remaining nine pencilling in a later ‘lift off’. In June, seven members forecast a rate rise in 2022.
Further ahead, one group within the FOMC expects rates to be above 2%, and almost back at neutral, by the end of 2024.
A second group, perhaps clustered around chair Powell, appears to think that despite low rates of unemployment and inflation being marginally above target, it will take longer to move away from the zero lower bound than during the previous cycle.
As a result of this split, the median of the dot plot is not as useful a summary statistic of the interest rate projections as it has been: it does not reflect the central view well.
US stocks rose after the Fed’s statement and chair Powell’s comments: the S&P 500 closed up by 1%. The US Treasury market’s reaction was more modest, with the yield curve flattening slightly. The yield on the benchmark 10-year US Treasury yield fell by 0.014 percentage points to 1.32%.
US debt ceiling en route to a compromise
It remains likely that bipartisan agreement will be reached to raise the debt ceiling before the X-date (mid-October to mid-November). There are rising risks that the Democrats will be forced to include debt-ceiling instructions within the reconciliation package.
Under such a scenario, spending may be watered down to around USD 1.8 trillion with USD 1 trillion in new revenues. Spending on items such as caregiving, education, and training could be cut. This could reduce both 2022 and 2023 growth by around 0.5%.
2023 ECB rate rise looks unlikely
A recent report in the Financial Times suggested an internal European Central Bank scenario put inflation at 2% in 2025 and that a possible rate rise in 2023 received considerable attention in the markets.
The idea of the ECB having inflation at target in 2025 is not completely out of the question, given the ECB’s current official 2023 inflation forecast of 1.5%. However, a 2023 rate rise would still be at odds with both the spirit of the latest forward guidance, which is to guard against premature rate rises, and with the overall dovish tone from the ECB when it comes to lift-off.