December Fed meeting US CPI and China reopening in focus

Chief Investment Officer's team

13 December 2022

decemberfedmeetinguscpiandchinareopeninginfocus

AT A GLANCE

Pockets of US economy strength amidst an overall slowdown phase
China reopening process gradual and completed by mid-2023
Fed Summary of Economic Projections key to confirming 5% terminal policy rate

Markets have continued to waver, caught between the carrot of peak policy rates and inflation and the stick of a slowdown that could worsen once higher rates start to affect the economy, hence corporate earnings, more deeply.

Indeed, the market-implied Fed terminal rate has stabilized at 5%, inflation may be sticky but seems to have peaked, so these positives should be reflected in the Standard Economic Projections and the ‘dot-plot’ to be released at the Fed policy meeting this Wednesday. Investors will be focusing in particular on the ‘dot-plot’, indicating the expected path of the Fed funds rate, with the hope that the Fed will stop hiking in Q1, implying little upside to Fed funds from current levels.

Ahead of the December meeting the highlight of the week will be the CPI report, due out on Tuesday. If peak inflation is considered somewhat of a given, its stickiness will be gauged, and become particularly relevant for future central bank action.

The reopening of China, cushioning the blow of DM protracted weakness, is expected by consensus to be completed by mid-year 2023. The stimulus measures undertaken by the authorities, as gauged via the Bloomberg China Credit Impulse Index, usually feed through to the economy about 12 months down the road. This means that the maximum effect of the credit impulse should be felt just about mid-year 2023. From this viewpoint, there seems to be plenty of room for risk assets to benefit from the reopening.

Please note that our weekly publication will take a year-end break and come back at the beginning of 2023. Stay safe.

Cross-asset Update

Three trends that have marked most of 2022 could be close to coming to an end: resilient US job growth, dollar strength and rising longer-dated Treasury yields.

The last jobless claims report, which is released each week on Thursday, could have important implications for the dynamics of the labor market. US continuing jobless-benefit claims rose to the highest level since February, hinting to slowing growth and moderating inflation ahead of this week’s Federal Reserve policy meeting. But this could be a benign reading. Scratching below the surface it turns out that continuing claims are now 27% higher versus the minimum of the past year, a threshold that since 1967 gets reached only when a recession is close at hand. Along the same lines, the Conference Board Employment Trends Index, released on Tuesday, fell in November for a second consecutive month, suggesting that the historically low levels of US employment might not hold for long. In particular, a senior economist at the Conference Board, said that “job growth may slow going into 2023”. So, this is the point, we could be approaching crunch time sooner rather than later, and finally witness an inflection point lower in the labor market. We shall see, then, if unemployment is set to rise fast, or gently as some hope, and that would make the difference between a hard and a soft landing.

In line with softening US growth the dollar is losing strength. The world reserve currency is usually in a bull market either when US growth is above peers, e.g. since 2021, or when global activity suffers, e.g. often wise during US recessions. If indeed the labor market turns and the Fed pivots, then barring the possible recessionary period dollar strength could definitely wane. In the shorter term we should see dollar resurgence, though, as Fed funds approach the 5% terminal rate, but then catalysts for further upside would be few and far between. With more than 80% of all US yield curves inverted, Treasury volatility near 10-year highs, and the terminal rate now stabilised around 5-5.25%, most of the factors that sustained the world reserve currency are indeed stretched. And dollar weakness usually comes alongside the outperformance of non-US equities. We shall see this time which market will take the baton.

This week the direction of US treasuries will be dictated by the important CPI inflation report and the Fed meeting. The Treasury market may have got ahead of itself by discounting peak rates and a deteriorating outlook. Chairman Powell remarked recently that the dot plot may reveal a higher median projection for peak rates in 2023, and inflation could turn out to be sticky. Yet, upside appears to be limited, in particular for longer-dated yields, if indeed higher policy rates will start to bite in 2023.

Fixed Income Update

The 10-year treasury yield was up by 9bps last week after dropping more than 44bps in the previous month. The 2s10s inversion remains near the 40-year low of -78 bps amid recession fears. The US PPI inflation released on Friday was slightly above market expectation causing yields to edge higher. The PPI stood at 0.3% vs expected 0.2%. The University of Michigan consumer sentiment index came stronger at 59.1 vs expected 57, continuing the rebound from its all-time low in July this year. US factory orders and the ISM service index also saw improvements. At the upcoming FOMC meeting, investors will remain watchful for guidance on the 2023 peak fund rate alongside the widely expected 50bps rate hike.

Last week, The Bank of Canada raised rates by 50bps as anticipated. The bank’s statement commentary suggested that further large increases had likely come to an end, at least for the moment. Following the Fed’s meeting, the ECB and BOE decisions are also due on Thursday, with consensus estimates of a 50bps rate hike for both. ECB officials will also be laying out the principles of QT. In the UK, there were some upside surprises in recent data, but growth momentum remains weak, indicating a mild recession. Core inflation in the UK is expected to remain elevated through the end of 2023.

In Asia, the Reserve bank of India raised its repo rate by 35 bps, and Australia’s Central bank raised its rates by 25 bps due to inflation concerns. The previous week was filled with CPI data of various countries, and the numbers were mixed across Asia. The Philippines CPI print recorded a 14-year high at 8% YoY due to higher food cost, while the CPI in Thailand eased to a 7-month low of 5.55% YoY. China’s CPI and PPI remained soft at 1.60% YoY and -1.30% YoY, respectively. Inflation in India is estimated at 6.35% in November, and the CPI may return to the RBI's 2%-6% target by January.

Coming to the MENA region, IG sovereigns saw a slight increase in yields due to limited flows. Saudi Arabia’s real GDP for Q3FY22 grew by 8.8%, with the oil sector being the primary driver for growth (14% YoY sector growth). The non-oil economic activities outside the government contributed with a share of 50.7 percent to GDP.

Equity Update

After two months of strong positive returns, December so far has seen most markets slightly in negative territory, barring China. Also, whilst the broader MSCI China Index was +7% last week, adding to November’s impressive +27% gains, worries remain, with the reopening raising concerns on the accelerated spread of Covid. China index gains have been helped by a rise in property stocks and we could see stability/ upside as the Chinese government may further improve its position on property policies at its upcoming Central Economic Work Conference. China has already implemented stimulus measures to help its struggling property market, including lowering the reserve requirements for its large banks. As we go into year-end, we will be holding our asset allocation strategy meeting this week but not expecting major changes in our positioning, with a close to neutral outlook for equities. Inflation remains a concern (more so for the West than Eastern economies) as it guides monetary policy, but we see green shoots around supply chain functioning and lower oil price already helping. Shelter too is trending lower, though wage growth remains sticky. The consumer pocket is also definitely smaller without COVID-fuelled stimulus, while retail data is indicative of bargain hunting and holiday sales growth is stagnating.

GCC equity indices fell last week, with the Tadawul KSA Index -5.9% in line with the drop in oil prices. Oil is at a one-year low, with rising global recession risks weighing on demand expectations. Additionally, the G7 Russian oil price cap went into effect. On the macro front it’s positive as Saudi Arabia's GDP grew 8.8% y/y in Q3, the fastest-growing in the G-20. UAE equities saw a flat performance from Dubai with Abu Dhabi equities -3%. The most recent IPO Americana, a franchise operator for popular restaurant brands, sees its stock market debut today. India performed in line with global equities falling close to 3% last week. Inflation in India is estimated at 6.35% in November, and the CPI may return to the RBI's 2%-6% target by January, though industrial output likely fell y/y in October. India is both a tactical and strategic overweight.

All three major U.S. indexes ended the week in negative territory alongside the European markets that overperformed. The S&P 500 fell 3.4% with the Nasdaq a little more at -4%. On Friday, US markets were lower after producer-price data came in higher than expected. Stronger-than-expected economic data is reinforcing the continued need for monetary policy tightening. Yields on the 10-year U.S. Treasury note rose, and on the two-year note, which is more sensitive to near-term interest-rate expectations, also rose. With the US 2s10s curve inverted, it looks like the rates market remains ahead of the equity market in pricing a 2023 hard-landing scenario. Also, commentary from business leaders is fuelling recessionary fears. However, for the first time in 26 weeks there were more earnings upgrades than downgrades. For markets to move sustainably higher, Fed language has to indicate that a pivot is near and it can put the brakes on its policy tightening.

Written by:

Anita Gupta Head of Equity Strategy , [email protected]
Giorgio Borelli Head of Asset Allocation , [email protected]
Maurice Gravier Chief Investment Officer , [email protected]
Satyajit Singh Fixed Income Analyst , [email protected]

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