The Fed signals higher-for-longer interest rates

Chief Investment Officer's team

29 August 2022

Fed Chairman Powell delivered a hawkish speech on Friday at the annual Jackson Hole Symposium

AT A GLANCE

Fed Chairman Powell delivered a hawkish speech on Friday at the annual Jackson Hole Symposium
Markets sold-off sharply in reaction, with the perspective of more tightening for longer
Volatility remains extreme as expected, but we keep our positioning unchanged

Mr. Powell’s speech at the Jackson Hole Economic Symposium triggered a sharp sell-off on Friday. With almost -4% on major US indices, stocks erased more than one trillion in value after the 8-minute speech. In essence, Mr. Powell said that monetary tightening will continue for longer than expected, until inflation abates, through two key points. First, inflation is the core mission of central banks and they have to fight it, no matter if part of it is linked to supply, and regardless of the economic impact. Second, the Fed will continue until data materially illustrates the job is done: lower inflation and expectations. This implies more tightening for longer, continuing into 2023. His speech made several references to the past, especially inflation from the 1970s which only ended in the 1980s, when Paul Volcker’s radical tightening and credit policy, caused the loss of millions of jobs. Chair Powell notably said on Friday that “the historical record cautions strongly against prematurely loosening policy” – and didn’t any more mention a reassuring “soft landing”.

Following and including Friday’s sell-off, developed markets saw a -3.3% weekly drop for equity and between -0.6% and -0.8% for fixed income last week. Emerging markets were better, but of course Asian markets were closed during Powell’s devastating speech and risk aversion should reach them this Monday.

Now that hopes for an imminent pivot are killed, we are to some extent better prepared for an outlook combining anemic growth (resilient in the US, slow in China, contracting in Europe) with monetary tightening and slowly falling inflation. Apart from some unexpected escalation in geopolitics, several asset classes look adequately priced for such a backdrop, which is why we keep our current positioning. Stay safe.

Cross-asset Update

As we highlighted in the introduction, Jerome Powell said Friday that “the historical record cautions strongly against prematurely loosening policy”. Exactly a year ago at the same symposium, he was highlighting very different lessons from the past. At the time, historical records were advising monetary policymakers “not to attempt to offset what are likely to be temporary fluctuations in inflation”, as “responding may do more harm than good”. Those days are gone: inflation is not seen as temporary anymore. But if anything, this 180-degrees turn in a year reminds us of the difficulty of any forward-looking prediction. Actually, inflation forecasts have been wrong for the last 15 years or so, which in a way could be a source of hope, but certainly not a reliable input for investment decisions.

So, let’s have a look at facts, through three points.

First, economic growth: Europe is in a very tough situation with its energy crisis and it will be extremely difficult to avoid a recession. China is in a perilous place, but with vigorous stimulus, which may have started with the stimulus package announced last week (little more than 1% of GDP), and some radical action on real estate, it could do reasonably well, above 3% growth. Finally but crucially, the US looks resilient and looks able to avoid a (severe) recession.

Second, central banks will keep on tightening. However, some inflation measures are already trending lower, even if they remain above target and the comfort zone. To some extent, hawkish communication is part of the tightening toolbox and we prefer to see markets being prepared for the worst rather than dreaming about an imminent pivot.

Finally, certain assets, especially stocks from emerging markets or some safe bonds, are relatively adequately priced for the current outlook: anaemic growth, hawkish central banks and lower but still higher than average inflation. What could change is of course geopolitics. A worsening situation in Ukraine and a simultaneous escalation in Taiwan would be a nightmare scenario. Fortunately, China doesn’t seem to be willing to do more than the spectacular drills which followed the perilous Pelosi visit. With regards to Ukraine, it’s not impossible to think that social unrest in Europe -when insane energy bills reach households- could make political leaders turn a bit less inflexible towards the Kremlin.

Volatility should remain terrifying, which has always been our call for the summer, but the medium-term investment perspectives are not, taking into account what’s priced in and the level of pessimism in the system. Apart from a change in the geopolitical situation, markets should gradually learn to live with the current reality, while the combination of tightening and falling purchasing power should pressure inflation. Inflation has proven it wasn’t transitory, but it doesn’t mean it’s eternal.

Fixed Income Update

Last week ended on a cautionary note for the bond markets. Chairman Powell’s speech at the Jackson Hole symposium seems to have let the cat among the pigeons in the proverbial term. He was clear that rates remain “Higher for Longer.” This would inflict pain on the markets and the economy. However, he also warned everyone against the perils of premature loosening, referring to the lessons learned from the 1970s and early 80s. According to several FED members, the September rate decision remains data-dependent, the most important of which would be the August unemployment report and the inflation data to state the obvious.

The result of the comments was a bear flattening of the curve as the 3-year Treasuries moved up by 20 bps last week to touch 3.47%. This makes bonds with a duration of 3-5 years quite attractive. The 10-year went up by 14 bps and currently hovers around 3.10%. The yield curve remains inverted in the 2s10s part of the curve, though the 3month rate remains below the five-year and 30-year points. The movement in the yields resulted in negative returns across different sub-segments. However, emerging market debt bucked the trend with China’s stimulus starting. We remain cautious on the riskiest segments with higher FEDs for longer rhetoric. This week we could see most of the gains of Emerging Market Debt being given up.

Looking Eastward, there was a bit of relief for Chinese property developers. There was a sharp weeklong rally driven by news that some more vital private developers were preparing to issue RMB corporate bonds with guarantees from China Bond Insurance Company. However, the recent policy easing is unlikely to be extended to the most stressed private developers. Therefore, tail risk will remain fat within the China property sector.

According to recent Goldman Sachs report, flows into global fixed income funds were slightly negative (-$1bn vs. +$0.4bn in the previous week), mainly on outflows from EM across hard, blended, and local currency funds. On the other hand, flows across DM bond funds were mixed, with high-yield funds seeing the most significant net outflows as a percentage of AUM. Overall though, flows into DM were positive, as government funds saw a resumption of net inflows and Agg-type funds continued to see strong demand.

GCC bonds saw a differentiated performance. According to trader notes, Abu Dhabi performed well within the IG space while the KSA long ends lagged. High Yield sovereigns sold off, with Bahrain outperforming the Oman bonds complex. Regarding corporates, Acwa Power lost its IG rating as Moody’s downgraded it from Baa3 to Ba1. There has been a staggering 75% drop in primary issuance from the GCC region. ADCB announced a USD 5y green bond last week with roadshows starting this Monday. If this deal comes to the market, it would be the first primary issuance in the region since late June.

Equity Update

Global equities ended lower for the week, down 3%. Looks like the sunny summer is over for the markets with the Fed path and recession fears in the forefront again. 2Q earnings supported markets and guidance was not overly negative, but evidence of weakening demand, shifts in consumer spending with inflationary pressures increasing and inventory pressures for retailers stood out. The full impact of rate hikes on growth and earnings will become more visible in the coming quarters. US equities were down -4% for the week, with most of the fall on Friday post Fed Chair Powell’s more hawkish stance amid the backdrop of the mixed inflation data and the strong July job growth figures. Another "unusually large" rate hike could be appropriate at next month's Fed meeting even if it means some pain on the economic front. So far, the economy is holding up as illustrated by worker demand, a recent durable goods report that reflected a monthly uptick in business investment and big retailers with strong sales figures, a reflection of continued strength in US consumer spending. US treasuries have recently been volatile with the 2/10 yield curve steepening but remaining inverted, and the U.S. dollar has hit a new multi-decade high, affecting high growth sectors and those with large overseas earnings. The ECB is tailing the Fed but the high energy costs necessitate rate hikes and the economy and consumer in the Euro bloc appear less able to weather the tightening with possible energy rationing in winter for industrial users.

We had recently moved to a neutral Asia and China positioning from an overweight position, tired of all the to and fro-ing by regulators promising to ease up on tech companies and waiting for China’s economy to kick start post continuing lockdowns. Domestic travel is resuming but international travellers still face quarantining and few flights operate internationally. Whist the real estate slowdown remains a drag on the economy and on banks there are some green shoots. The US and China are close to an agreement to allow US regulators access to audits of Chinese companies that are listed on US exchanges. ADR’s of Baidu, JD.com and Pinduoduo, have been trading higher in hope of a resolution. Earlier this month, five state-owned Chinese companies said they would be delisting from US exchanges before they get ousted in 2024 as a result of the pending ban. We advocate a market neutral weight for China equities.

Other Asia economies and markets continue on an uptrend. The UAE had another week of gains amidst real estate developer Emaar Properties announcement to vote for an increase in Foreign Ownership Limits. UAE corporates have been slowly raising eligibility for foreign owners as have KSA listed companies and the regional weight of the GCC in the EM index is currently 8%. Relaxed FOLs would lead to a further allocation to the GCC and consequent passive and active flows.

We have a close to neutral outlook for equities and as we said at the beginning of the summer, markets will continue to react to Central Bank rhetoric, inflation and geopolitics. Earnings remain the most important determinant of equity performance, hence selection remains key with a preference for regions, sectors and corporates with resilience in earnings growth.

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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