It has been a been a positive week for financial markets, rounding off a strong month of returns in November. Financial markets took hope from Federal Reserve Chair Jay Powell’s speech on the outlook for rates (and ignored all the hawkish comments on rates staying higher for longer), while in China, as protests against Zero-Covid were suppressed, the market mood remained positive on the hope that policy is moving towards looser restrictions even as Covid case numbers reach record highs.
US markets rallied strongly on the back of a speech by Federal Reserve Chair Jay Powell, who again signalled that the Fed may well ease the pace of interest rate hikes at their next meeting on 13-14 December. While much of Powell’s speech was a repetition of previous comments, investors focused on his comment that “the time for moderating the pace of rate increases may come as soon as the December meeting”. This echoes his previous comments and those of his colleagues that after 4 consecutive rate hikes of 75bps, a 50bps hike will be appropriate at the next meeting. Powell’s more hawkish comments on the terminal rate and how long rates would be in restrictive territory were ignored – this is a stock market that wants to go up right now. Powell said that the “ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting” and restoring price stability “would likely require holding policy at a restrictive level for some time”. Fed Funds futures chose to ignore these comments and the pricing for the terminal rate fell back below 5% while futures also imply rates will fall over the second half of 2023 to 4.43% by December. Wishful thinking? Quite possibly. In the 8 hiking cycles since 1974, the Fed Funds rate has always peaked above the level of inflation. While US inflation has eased from 9.1% in June to 7.7% in October, it remains a long way from the Fed’s 2% target. Inflation likely will continue to ease, but rates will also continue to rise from the current 3.75-4% range. Powell said, “my colleagues and I do not want to overtighten”, acknowledging concerns that the Fed may end up going too far. He also noted that “the full effects of our rapid tightening so far are yet to be felt”. Hence a continuation in rate hikes but at a slower pace, then holding them at an elevated level versus inflation appears to be the roadmap the Fed is describing. This remains out of sync with US markets that are rallying in expectation that the Fed will make a bigger pivot than they are currently suggesting.
The economic data has seen the PMI manufacturing indices updated for November though they final numbers were little changed from the ‘flash’ releases that I commented on last week. The data suggests the UK and eurozone are in economic contraction, while the ISM equivalent of the PMI data in the US shifted lower and into contraction territory. This was the weakest level since May 2020. While the services data to be published next week will give a broader view of the economy, the weakness in manufacturing and the underlying data on inventories, employment and new orders all point to a slowing economy, albeit not at the pace seen on our side of the Atlantic. We also saw updated inflation data for the eurozone, with November inflation lower than expected at 10% year on year, down from the 10.6% all time high reported in October. Core inflation, which excludes food and energy prices, was unchanged at an all time high of 5%. Earlier in the week European Central Bank President Christine Lagarde said there is “too much uncertainty” to assume that inflation had peaked, not least given the risks of higher wholesale energy prices being passed through to the retail level. Lagarde said “it would surprise me” if October was the peak in inflation. Her colleague, Klaas Knot of the Central Bank of the Netherlands said he saw inflation risks “tilted entirely to the upside” and described talk of over-tightening by the ECB as “a bit of a joke”.
In China last weekend saw significant protests across major cities highlighting how public patience with ‘Covid-zero’ is wearing thin. The trigger for the protests appeared to be the death of 10 people in an apartment fire in locked-down Urumqi. Images of unmasked football fans enjoying the world cup have also served to remind the Chinese that while most of the world has moved on from Covid restrictions, hundreds of millions of Chinese people remain under restrictions. The solutions in the short term appear to have been to suppress protests by deploying significant numbers of police and security personnel in visible places across the big cities and alter the World Cup images so that Chinese views cannot see the crowd. We have also seen restrictions on internet access and student sent home from universities. Financial markets appear to be hopeful that the public protest will accelerate a shift away from current Covid policies even as case numbers make record highs. There is clearly a path out of Zero Covid – we have seen this in Australia and New Zealand. The key is to ensure a sufficiently large proportion of the population is vaccinated. While the overall vaccination rate is around 90% for the 1.4 billion population of China, this falls to 66% in the over-80s and only 40% of this age group have had a booster. All of these numbers refer to the domestic made vaccines, which have a much lower efficacy than their western counterparts. The Chinese authorities have to balance social, economic and political risks of lockdowns on one side with the risks to the healthcare system, and ultimately higher mortality rates on the other. Some hints at policy shift have been forthcoming – the government indicated it will seek to increase vaccination rates for the elderly and said local officials should avoid “excessive” restrictions. We have also learned that some infected people will be allowed to quarantine at home rather than in detention centres. Chinese Vice Premier, Sun Chunlan, said that “as the omicron variant becomes less pathogenic, more people get vaccinated and our experience in Covid prevention accumulates, our fight against the pandemic is at a new stage and it comes with new tasks”. We watch and wait with interest as to what these new tasks will be…
