The Fed’s scope to tighten is limited
Ariel Bezalel, Head of Strategy, Fixed Income says unfavourable structural factors combined with prospects of subdued growth and inflation outlook may preclude aggressive tightening from the Fed.
The key feature of bond markets in recent weeks has been the aggressive flattening of yield curves around the world. Some cite the hawkish pivot by Federal Reserve Chair Jerome Powell towards the end of November as a driving factor, while others blame the spread of the Omicron variant.
The flattening started in the beginning of March and the 30-year US Treasury yield peaked that month. The situation is reminiscent of 2005 when, despite tightening from the Fed and the strength of the economy, the yield curve continued to flatten. It’s what Alan Greenspan then called “a bit of a conundrum”. Today, the yield curve is flatter than during the Covid crisis around February to April 2020.
Despite the anxiety over inflation among investors right now, in my view inflation is likely to roll over quite a bit over the coming year due to base effects and an easing of bottlenecks. The risk could, in fact, be too much product hitting stores at a time when consumer demand has been satiated. Other longer-term factors are also likely playing their part in suppressing yields at the long end, such as too much debt and pernicious demographics in much of the developed world and in some of the leading emerging market countries.
Going forward, the flattening of the curve is likely to be exacerbated by Fed tightening in the coming months (with the likely acceleration of the tapering program) and a fiscal cliff in 2022. This means the growth and inflation picture will be somewhat subdued, limiting the ability of the Fed to tighten much. I think the hikes that have been priced into markets today are probably too aggressive, with potentially two or three rate hikes next year, followed by another three to four the year after.
Another area of interest is what China may do to support its economy. We’re seeing early signs of some sort of reflation, with the authorities introducing some easing measures. This is meant more to stabilize the economy rather stimulate aggressively like they have done in the past. But as the problems in China become more severe, we may see a more heavy-handed response over the course of 2022.
UK growth data disappoints – but what about spending?
Dan Nickols, co-Head of Strategy, UK Small & Mid Cap, looks under the hood of some disappointing economic growth data from the UK, and discusses what may happen to the savings ratio and discretionary spending in 2022.
One should not get carried away by a single data point, but it is worth noting that the UK’s GDP growth for October, which was released last week, disappointed in a number of ways. Overall, UK GDP came in at just 0.1% (below the 0.4% consensus expectation), putting the UK economy about 0.5% below its pre-pandemic level.
Looking beneath that at the moving parts, industrial production fell 0.5% month-on-month (now 2% below the pre-pandemic level). The most worrying aspect of October’s economic data was that hotels and restaurants fell 5.5% month-on-month. Obviously this relates to a period before the emergence of the Omicron variant, so it’s not going out on a limb to suggest that even worse data is coming for that sector. It’s also probably not a good sign in the circumstances that health output (face to face doctor’s meetings, Test and Trace, etc), which rose 2.6%, helped keep the overall growth figure on the right side of zero.
On a more positive aspect, services did grow 0.4%, with the retail component growing 1.4%. Alongside anecdotal reports of good sales in November’s ‘Black Friday’ event this bodes well for the rest of the year in retail. Taken all together, however, this data does mean I am starting to become incrementally more cautious about the UK’s growth outlook.
One area where I’m minded to think more positively is around the potential for consumer spending to rise in 2022. The UK’s savings ratio remains high at 12%, and arguably mean reversion (the long-term average is nearer 5%) could materially drive consumption in 2022. Some scepticism around that outcome is understandable. Yet it is worth remembering that, if the UK and global economy does slow due to Omicron, then energy cost pressure may abate, putting some cash back in the pockets of consumers. What is more, discretionary spending is very sensitive to changes in the savings ratio, with typically a 1% fall in the savings ratio corresponding to a 3% uplift in spending. So it isn’t necessary for the savings ratio to fall all that far in order to have a meaningful impact on spending, and by extension the fortunes of companies reliant on that spending.
For me, the key question is whether there is enough momentum in the UK employment market to give households confidence that they can let their savings levels fall in favour of spending more? My feeling is that despite everything there probably is sufficient momentum, and if so then a reasonable level of growth in consumer spending in 2022 should materialise. This leads me to favour exposure to a balance of structural growth companies (typically on high valuations, but not excessively so) alongside an array of lowly-priced economically sensitive businesses.
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