What do US markets expect from the Fed?
Markets seem to believe that the slowdown in inflation may prompt the Fed to change pace. The analysis of Richard Flax, Chief Investment Officer of Moneyfarm
Last week the financial markets celebrated one of the best days in recent times thanks to the inflation data in the United States, which seems to confirm a gradual normalization of price growth. Inflation in October stood at 7.7%, surprisingly positive compared to economists' forecasts. This caused bonds and stocks to rally sharply, while the dollar weakened.
US inflation has proved more resilient than many expected in recent months, even when other economic indicators would point to a slowdown. The slowdown in inflation in September had been less significant than expected and, as a result, the US central bank had adopted a more aggressive rhetoric which had a negative impact on equity values.
The October figure goes against the trend, showing both a deceleration (from 8.2% yoy in September to 7.7% in October) and a better-than-expected result (7.7% against 7.9% expected by analysts). This is true for both consumer and core inflation (excluding food and energy).
The markets seem to believe that this slowdown in inflation could lead the US central bank to adopt a more expansionary policy rate than expected. It could be a bit premature, because we are looking at a single figure that is not yet trending and the road to reaching 2% inflation is still long. But after a few months of inflation disappointment, it is reassuring to see some progress.
The sharp movements we have witnessed certainly tell us something about the climate on the markets today. Many investors had allegedly bet on a disappointing inflation outcome, and this made trading volatile.
Close attention will be paid to forthcoming Fed statements to seek confirmation of a more dovish narrative. The hope is that upcoming macro data says this is just the beginning of a trend towards weaker demand and better balance.
This improving situation could prompt an increase in the weight of risky assets in the portfolio, taking advantage of valuations, but in the overall management of an investment portfolio, certain risks must not be underestimated which, if they materialise, could negatively influence the situation. Here they are listed below.
Energy crisis
The energy crisis risks worsening further and could trigger a liquidity crisis for European energy companies, putting the economic system of the geographical area into crisis and certainly worsening the recessionary expectations for the global economy in general.
In recent months, in fact, the volatility of commodity prices has highlighted the fragility of the balance sheets of energy companies, which must run away from changes in prices in the future. To do this, companies use a significant amount of derivative instruments that require collateral, i.e. an amount of cash (or similar) that guarantees that they are able to pay the counterparty in the event that the derivative position loses.
To give an idea of the scale of the problem, Sweden has proposed a 23 billion credit line for its energy companies. For the moment, the situation seems manageable, both because the prices of raw materials have partially normalized and because the regulators have declared themselves ready to intervene in support. However, if the geopolitical situation were to worsen or if China's reopening were more marked than expected, putting pressure on the prices of energy resources, the prospects for the European economy would be very bleak.
The real estate sector in China
China remains in a very complicated situation. Despite the easing of some anti-Covid measures, the world's second largest economy looks more fragile than ever. The real estate market continues to falter due to a new, worrying trend of Chinese consumers who continue to block payments for new construction. Traditionally, builders require about 30% of the payment upfront, a share which is then systematically used to finance new projects, rather than to quickly complete those already started. Lengthy lockdowns have further delayed the completion of already sold and partially paid for properties, sparking protests, boycotts and putting pressure on real estate liquidity. Furthermore, to make matters worse, Chinese banks have "half-closed" the credit taps for the sector, in order to comply with government regulations on maximum leverage levels of credit institutions and due to fears related to an industry that, after the Evergrande case seems decidedly on the bubble.
In our opinion, although the situation should not be underestimated, the government has reacted promptly, with a series of measures sufficient to provide stability. In particular, the Chinese Communist Party has intervened both by stimulating the demand for mortgages (for example by lowering rates), and by establishing aid funds for the completion of real estate projects, with almost 800 billion yuan already allocated. For the moment, the markets are satisfied with the measures adopted and the demand for mortgages has started to rise again, giving hope for a gradual improvement in the situation. However, the government's increasingly authoritarian drift and less attention to market logic could lead to less market-friendly measures and worsen growth expectations.
Geopolitical risk: Ukraine and Taiwan
The global geopolitical situation remains the main unknown. First, Putin could follow up on his threats and test tactical nuclear weapons, causing an unpredictable escalation and a possible conflict with NATO. On the other side we have Xi Jinping, who obtained his third term as head of the General Secretariat of the Communist Party. A historic event, given the longevity of Xi's power, which has been in office since 2012 and will continue to be so for the next 5 years. A mandate that brings with it various challenges: economic (growth challenges well below the Chinese average), political (his third term could generate long-term instability) and geopolitical. In fact, during the Congress, the leader reaffirmed his willingness to annex Taiwan by 2024, consequently increasing fears of an open conflict on the island. The United States could intervene in the event of an invasion, with clearly catastrophic effects for the global economy.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/mercati-fed-aspettative-inflazione/ on Sun, 20 Nov 2022 06:59:20 +0000.