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Weekly investment update – One central bank, two central banks, three central banks...

Over the last few days, equity markets have bounced back on news of negotiations in the Ukraine conflict. We would not try to predict the outcome of these talks, but to us, investors appear complacent about the odds of diplomatic success. Anticipating political outcomes is likely a poor strategy for asset allocation decisions in the short term.  

On the monetary policy front, sentiment has been dominated by more hawkish policy turns by the European Central Bank (ECB) and the US Federal Reserve (Fed), boosting long-term yields. The Fed has raised policy rates by 25bp while the Bank of England has followed suit with an equal-sized move.

Markets have been anticipating rate rises. Already high inflation seemed set to rise further as a result of the Ukraine war even as economic growth will likely slow.

At the end of 16 March, the yield on the US 10-year T-note stood at 2.18%, up +23bp in one week and +36bp from the end of February. The 10-year German Bund yield had risen to 0.39%, its highest  level since mid-November 2018 (see Exhibit 1). Between 9 and 16 March, global equities gained 1.6%, leaving the month-to-date loss at -2.1% (MSCI AC World index in US dollars).

China – A contrarian central bank

While Europe is particularly exposed to this geopolitical crisis, the Omicron BA.1 wave has hit Asia, reminding us that the health crisis is not over. The rise in new cases in China has led to the imposition of strict confinement measures in Shenzhen, a city bordering Hong Kong, and Changchun in the northeast. According to the latest National Health Commission report, 1,952 new non-imported symptomatic cases were identified on 15 March in more than a dozen Chinese provinces and cities.

The authorities are aware of the effects of their zero Covid policy on economic growth and financial markets: the yuan has depreciated, and the CSI 300 Index has fallen to its lowest since June 2020, though there are additional factors behind these moves. Last week’s announcement of an ambitious GDP growth target of 5.5% in 2022, and the emphasis on the importance of ‘stabilising ‘growth, suggest more fiscal and monetary support is to come to offset the drag from the pandemic.

Since January’s key rate cut, the People’s Bank of China (PBoC) has kept banking system liquidity ‘reasonably ample’, but further cuts are now expected. On 16 March, Deputy Prime Minister Liu He hinted at more market-friendly policies, including a softening of regulations, particularly those affecting the tech sector.

Elsewhere, monetary tightening is on the agenda

While the PBoC’s easing stands out, one could argue that the current geopolitical situation and the associated downside risk to growth justify a more cautious approach elsewhere, too.

To date, the ECB has kept its deposit rate at -0.50%, but it did signal earlier this month that the pace at which it will reduce its securities purchases will be more aggressive than suggested before. The PEPP (pandemic emergency purchase programme) is due to run out by the end of the month, while the expansion of the APP (asset purchase programme) will be more limited. 

These announcements and comments from the ECB that the first rate increase will occur ‘sometime after’ the end of net purchases of securities have led observers to anticipate that the first hike in rates will come at the end of Q3 or at the beginning of Q4, with the deposit rate returning to 0% by the end of 2022.

While we have now revised down our GDP growth forecast for 2022 (from 4.2% previously to 2.8%) and consider that risks to growth are to the downside while those on inflation are to the upside, we expect a first rise in key rates in December 2022 and further policy normalisation in 2023.

Ensuring greater policy ‘optionality’ by adopting a data-dependent approach could facilitate the ECB’s communication in the coming months and avoid over-interpretations of any changes in tone.

The Fed is more predictable than the ECB

As widely expected, the FOMC (Federal Open Market Committee) meeting on 16 March decided on a 25bp increase in the federal funds target rate. Only St Louis Fed President James Bullard, who over recent weeks had clearly opted for a more hawkish stance, voted for a 50bp rate rise.

The ‘dot plot’, which reflects FOMC thinking on the future rate path, now shows that four rate increases are envisaged in 2022 in addition to those already suggested in last December’s edition, resulting in a median projection of 1.875%. The additional hikes come even as GDP growth was revised down from 4.0% to 2.8% (Q4 year-on-year change). The Fed still expects low unemployment (3.5% at the end of 2022 and 2023, 3.6% at the end of 2024) but above-target inflation (core personal consumption expenditures excluding food and energy price index) at 4.3% in Q4 2022, falling to 2.7% at the end of 2023.

To us the message is clear: Despite the adverse effects of higher inflation on the economy, domestic demand is expected to remain strong in the US in the coming years and GDP growth will be above-potential growth. The inflationary pressures, which are not exclusively due to higher energy costs, provide ample justification for policy tightening.

Indeed, the pace could be sped up as chair Jerome Powell has signalled. Furthermore, he has suggested that the ‘passive run-off’ of maturing assets on the balance sheet could start as early as April.

Next up will be the question of the extent to which tightening monetary policy will slow growth. But for now, the outlook is for bond yields to rise further in both the US and in the eurozone.

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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