Twit in Chief

April 29, 2022

Are we set to see the return of Trump?

The past week has seen the move higher in central bank rate expectations start to weigh more heavily on risk assets, with equities correcting, led by tech stocks and those names that have been trading at very elevated earnings and sales multiples.

We expect that the Federal Reserve (Fed) won't be too alarmed at this price action. Feedback from our meetings in Washington this week suggests that there was considerable disquiet at the Fed in the wake of the March hike, when equities subsequently rallied and policy action had a negligible impact on overall measures of financial conditions.

In many respects, Fed policy aims to target broad measures of financial conditions, as these have a much more significant inference on the economy than a simplistic target will, such as the current Funds rate. With monetary policy working with lags, this forward guidance is commonly used by central banks in order to shift expectations and help support or restrain aggregate demand.

In this context, measures of US financial conditions remain very accommodative, which is not surprising with interest rates so far below rates of inflation. Yet, market disdain at the Fed's desire to start to tighten financial conditions can be seen as a catalyst for a much more hawkish stance since the March FOMC, though it seems clear that this message is beginning to get through to market participants.

US mortgage rates have risen more quickly than they have done since 1981. Meanwhile, the rise in 5-year real yields has been the most dramatic since the Taper Tantrum almost 10-years ago – albeit from extremely low levels.

Elsewhere, US high-grade fixed income indices are now down around 10% on the year, with equities posting similar losses. In addition, the past week has seen a material strengthening of the US dollar against all other major currencies. The cumulative effect is that financial conditions have now moved in a manner consistent with what the Fed would want and expect to occur as it seeks to withdraw monetary stimulus.

This suggests to us that the FOMC does not need to overplay a hawkish message at next week's meeting. A 50bp hike is universally expected, with indications of a similar-sized move to follow in June.

Thereafter, the course of policy may become less certain with inflation slowing and risks to growth building on the downside.

A US recession remains a possibility in 2023, though we see the Fed as alive to this risk and attentive to incoming data. Ultimately, a recession becomes more likely if the Fed needs to keep hiking beyond a perceived assessment of where the neutral rate sits, which policymakers estimate is around 2.5%. In turn, this will hinge on the trajectory for inflation.

There are good reasons to believe that price rises will be back below 4% by the end of this year and on a declining trend. This may enable Powell and colleagues to take a more measured approach to rates later in the year after a more assertive stance in the next few months, as pressure on the Fed to act starts to abate.

This being the case, we are tempted to think we have now seen the top in US bond yields for the time being. However, on a relative basis, we see eurozone fixed income as more compelling and have been adding to duration there. In contrast to robust momentum in the US economy, we think that much of Europe could already have tipped into recession in the wake of the shock to energy prices.

The ECB is committed to tightening policy, ending asset purchases in June and raising rates as early as July. However, hopes for a robust year of growth have been dashed, and although the ECB will feel obliged to respond to overshooting inflation, we think it unlikely that rates will rise much beyond 0% in the year ahead, once price pressure moderates. Latest CPI numbers in the eurozone were mixed, with some signs of year-on-year figures topping out in places like Spain, while Germany trended higher.

However, leading indicators, such as consumer confidence in Germany, are already ringing alarm bells and are at global financial crisis (GFC) lows, making for a tricky backdrop for eurozone policymakers.

Elsewhere, we retain a negative view on UK Gilts and the pound. There are clear signs that inflation in the US and eurozone has already peaked, but we see April data (to be released in May) in the UK pushing inflation towards double-digits, further undermining BoE credibility.

With the BoE MPC meeting next week, recent BoE communication has leant towards growth risks over inflation risks – a hazardous strategy if inflation expectations de-anchor further. The BoE’s reasoning has been that the squeeze in real incomes will sap demand and help return inflation to target, and that having already raised rates three times in the current cycle, they are already close to ‘neutral’.

The BoE remains an outlier in that respect among developed market central banks, which continue to push the hawkish accelerator – the Swedish Riksbank providing the latest example. It makes for a pretty ugly backdrop for UK assets in general, at a time when relative economic growth is starting to wane, according to IMF economists, placing the UK at the bottom of the growth table among G7 countries in 2023.

The past week has been challenging for risk assets and we still see scope for equities to correct further. This may continue to weigh on credit spreads.

Meanwhile, we have been picking-up voices of concern in areas like private equity, where the drive for returns appears to have driven leverage and some excess risk-taking behaviour, which could see heavy losses as companies need to refinance.

On the whole, we think that retaining a modest credit risk beta remains appropriate for now. The same is true in emerging markets, while in FX, we hold to our strong dollar bias but may begin to realise gains on a move below 1.05 versus the euro.

Looking ahead

The path remains uncertain and a cautious overall investment stance is merited. Central banks are poised to deliver material tightening of policy, which is expected to tighten financial conditions. This represents a strong headwind and we also perceive that many market participants have yet to realise that the Fed is not their friend.

Without having mentioned events in Ukraine or Covid measures in China this week, there is an abundance to talk about. In that context, maybe Musk's idea to raise the word limit in Tweets may come as a welcome development. Meanwhile, it will be interesting to see if Trump now returns to the platform (surely he won't be able to resist) in order to usurp Elon and reclaim his position as Twit in Chief.

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