Markets Weekly podcast - 13 December 2021

Henk Potts (HP): Hello. It’s Monday, 13^th December and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets, and grabbed the headlines, over the course of the past week. We’ll then consider the outlook for US rates, and the implications for fixed income investors. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investors bought on the dips, and returned to risk-on mode during the course of last week, as optimism over the health situation grew, economic data remained encouraging, and China provided policy support.

Risk sentiment got a boost from reports that symptoms from the Omicron variant have proved to be relatively mild, and vaccine efficacy, after a booster, is holding up. Preliminary data from South Africa showed hospitalisation rates have not surged as a result of the new strain. Drugs maker Pfizer-BioNTech said initial lab studies show a third dose of their COVID-19 vaccine neutralises the Omicron variant.

So, it was a week of impressive gains for equity markets last week. The STOXX 600, in Europe, was up 2.8%, its biggest weekly advance since 12^th March. A very similar picture over on Wall Street. In fact, the S&P 500 rose 3.8% over the course of the trading week, its biggest weekly advance since 5^th February.

However, the recent weakness in cryptocurrencies continued. Bitcoin fell for a fourth consecutive week. Bitcoin hit a record $69,000 on 10^th November, but it’s around $49,000 this morning, although still up around about 70% year to date.

In terms of the macro data, well, China took steps to support the economy during the course of last week. The central bank cut the amount of cash that banks must hold on reserve. It’s the second time the People’s Bank of China has cut the reserve requirement ratio this year. The 50 basis point reduction releases 1.2 trillion yuan, or $188 billion, of long-term liquidity into the economy.

The central bank said they will guide financial institutions to actively use the release funds to step up support for the real economy, specifically targeting smaller companies. In terms of the economic outlook for China, there are three major headwinds to its growth prospects over the course of next year.

Firstly, contracting property sales and investment, as changing house price appreciation expectations and a looming property tax could reduce investment demand for housing, and consequently home sales.

Secondly, the ongoing energy shortage, and the related increased pressure for China to meet its climate goal next year, which is expected to continue to infringe upon industrial production.

Thirdly, China’s zero COVID-19 strategy could be maintained through the course of 2022, holding back household consumption.

If you look at China’s growth profile, well, we expect fourth-quarter China to slow quite significantly down to around 2.8%. Then, for 2022, we’ve downgraded our forecast to 4.7%. That compares to an expected 8% growth rate during the course of this year.

Given the weaker environment, we expect additional policy response, so in terms of policy expectations, now forecast one round of 5-10 basis point policy rate cuts by March 2022, and one more reserve requirement ratio cut in the first quarter of next year.

In terms of the long-term outlook, China, we think, will continue to make the transition to focus on the quality and the sustainability of growth, rather than the headline speed, and we look to see China modernising its supply chains, and upgrading its industry to focus on high-end manufacturing, thereby moving away from its reliance on cheap labour and low-end manufacturing, to focus on becoming a responsible, high tech, domestic-consumption-led economy, which we think will be positive for the global economy to continue to make the region an attractive long-term investment.

Moving on to the UK, where the economic recovery moderated in October, GDP growth came in lower than expected. The UK economy grew at just one-tenth of 1%, month on month. Consensus was for a stronger growth figure, somewhere closer to four-tenths of 1%. The UK economy is still six-tenths of 1% below its pre-pandemic level.

In terms of the breakdown of performance, well, positive services was the key growth driver, up four-tenths of 1%, specifically health, due to more GP appointments, test and trace, and vaccinations.

Consumer facing services also provided a positive contribution, led by wholesale and retail sectors, as consumers brought forward Christmas spending. For weakness, well, there were some clear areas. Industrial production declined six-tenths of 1%, construction contracted by 1.8%, reflecting continued supply-chain constraints.

In terms of the outlook for the UK economy, well, in the short term, Omicron is already having an impact. So, if you look at some of the high-frequency data, it shows the number of seated diners, for example, has fallen since the start of the month. If you look at Barclays’ spending trends, they’re also showing a clear slowing in spending growth.

This week’s PMI and consumer confidence figures are also likely to reflect the impact of the disruption being caused by the highly transmissible variant. In terms of the policy impact, well, before Omicron, we previously expected the MPC to hike rates by 15 basis points at this week’s meeting, driven by the elevated inflation levels and, of course, the positive labour market recovery.

We think, given the uncertainty over the path of the pandemic, and the resulting impact on the economy of those renewed restrictions, we now expect the MPC to delay that first rate hike into next year. We think the Bank of England could start with a 15 basis point hike at the February meeting.

Beyond the immediate medical risks, we think the UK economy looks set to encounter some significant challenges in the medium term, including ongoing disruption to supply chains and labour shortages due to Brexit.

The impact of higher corporation, national insurance and dividend taxes, as we’ve already highlighted, higher interest rates, the resulting slowdown we think could then force the MPC to reverse hikes, in terms of rates, as we go through the course of 2023.

In the US, investors are bracing themselves for a multi-decade high inflation print, and that’s exactly what they got on Friday. CPI rose six-tenths of 1% month on month, or 6.8% year on year, in November, which is the fastest annual rate since 1982. The increase in price pressures was driven by higher energy, shelter, food, and used-car prices.

In terms of the outlook, inflation has certainly been higher, and more persistent, than projected. Supply chain disruption could continue to create price pressures given the Omicron effect.

Shelter costs, which, to remind you, makes up around about a third of the consumer price index and tends to be stickier than other types of inflation, was up 3.8% year on year. That’s the fastest rate since 2007, and is forecast to continue to rise during the course of next year, as rising rents, and higher home prices filter through to the measure.

Food at home prices also rose significantly, up 6.4% year on year. If you’re looking for signs of some downward pressure, perhaps you could find it in fuel prices, which have been moderating, and should be reflected in future prints.

In terms of the policy impact, well, the solid inflation report, coupled with recent evidence the US economy’s moving closer to full employment, is likely to encourage the Fed to quicken the pace of policy normalisation. In order to discuss that, and the outlook for US rates, I’m pleased to be joined by Michel Vernier. He’s Head of Fixed Income Strategy for Barclays Private Bank.

Michel, great to have you with us today. It seems the Fed has turned far more hawkish over the course of the past few weeks, as we’ve been discussing. Presumably it’s been driven by the persistently higher levels of inflation, and the remarkable recovery that we’ve been seeing in terms of the labour market. Is that your view in terms of the pivot that we’ve seen from the Federal Reserve?

Michel Vernier (MV): Yes, indeed. While the change in tailwind, and the Fed minutes end of November, could be noticed, Powell voiced loud and clear, during the recent Congress hearing, that factors that are causing high inflation to be more persistent. And Powell added policy has adapted to that and will continue to adapt.

Now, remember the Fed has over relied on that transitory nature of inflation, and the Fed’s initial plan was to simply look through this period. Now, after having officially retired, in Powell’s own words, the expression “transitory” can be argued that the Fed simply cannot not hike rates.

Remember, the conditions for a path to normalisations are, first, PCE inflation is expected to remain above 2% for some time. And, two, labour market conditions have reached levels consistent with maximum employment. We’ll speak about labour in a minute.

All what we’ve just said was before Friday’s inflation print at 6.8%. This means the rate is now over 4% for over eight months. Now, we don’t want to suddenly ignore these extraordinary factors causing the spike in inflation. There are factors like energy, car prices, and other goods and services, which simply have been caused by pent-up demand and temporary factors, and it seems extremely unlikely that these factors persist, which would ease inflationary pressure. And the Fed and most economists do agree on that.

But there are other factors which could point to more persistent inflationary pressures, like rents and wage growth, which both have picked up in recent months. One could speculate that the Fed may have even tried to tolerate this trend for some months, until the picture gets clearer. But there was a very distinct change in the Fed’s narrative, and this is why we believe the Fed may see some urgency now.

Now, we’ve pointed many times, and it comes back to the employment topic which we’ve just mentioned, that Jay Powell, during the cycle, has a much higher focus on a broad job market recovery, and up until now he would have argued that a period of high inflation could be tolerated, if this would bring the recovery in all income classes and ethnic groups. But this has now changed.

In his recent communication, he echoed earlier Fed speeches five years ago, and he has not done this up until now. He’s said to get back to the great labour market we had a recovery, we had before the pandemic, we’re going to need a long expansion, he said, and to get that we’re going to need price stability.

Now, with this statement Powell made it now ultimately clear that instead of letting the economy running hot, in order to remove the slack in the job market, he focused now on keeping inflation down, in order to pursue this important target of job market recovery.

HP: Well, given the dramatic pivot that we’ve been talking about, when do you think we’ll see that first rate hike? I think we’ve previously said a hike in the second half of next year. Has this now changed?

MV: Yes, you are right. It’s very likely that it will be earlier, given the Fed now sees a need to tame inflation in order to prevent the setback on the job recovery. We now think a hike is possible, if not likely, in the first half of next year, possibly early second quarter.

Now, the timing will also depend on the tapering pace of the current asset-purchase programme. Also here, the Fed strongly indicated a need for a quicker rundown. The Fed said that earlier dollar purchases adds to accommodation in a period when inflation is already high, and the job market has recovered. And given these circumstances, he said, it seems appropriate to consider wrapping up the taper of our asset purchases, perhaps a few months’ sooner, that’s what he said.

So, in other words, towards the end of the first quarter. And this in turn could pave the way to a first rate hike, as I said, in the early second quarter already.

HP: So, what impact do you think the dramatic change in policy will have on Treasuries? Surely, this must push yields much higher than initially anticipated. What is your take here?

MV: Yeah, it does and it does not. You know, Henk, in the bond market we like things complicated. Yields in the 2-5 year segments have already started to rise in anticipation of an earlier hiking cycle. The front end of the curve is now pricing almost three hikes for 2022.

Now, the picture looks somewhat different when looking at the long end of the curve, so 10 years, 30 years. US 10-year yields dropped from 1.65 to around 1.45, since the last release of the Fed minutes. Admittedly, this coincided with rising concerns over the Omicron variant, but the long end of the curve seems to feel more comfortable with a more alerted Fed trying to tame inflation, finally.

So overall, we see a continuation of the trend of flattening, whereby short end rises and the long end is trying to find the likely level of the long term, new, neutral, longer-term rate, which seems more in the range of 2% and lower at this time. And rate spikes are still possible, but overall rates just below 2% at the long end seems our base case.

HP: So you’re anticipating some rate hikes as we look through the course of next year. What would be the main risk to your base case scenario, Michel?

MV: Yeah, I’d probably kind of widen that out to the overall bond market when it comes to the risk. And there’s only one correct answer to this, which is, yes, of course, there are risks that could play out slightly differently. And by all means the market is never moving in straight lines, so expect volatility in rates.

What are possible scenarios? I mean first of all, inflation staying elevated for a much longer period, and at that point it may not even be of importance to the rate market, whether this is caused by bottlenecks or more persistent factors, like shelter for example. But an absence of any signs of inflation easing would swiftly raise doubts among bond investors, and that could lead to a repricing at the longer end, potentially, driven by even higher breakeven inflation rates, and higher nominal rates as well. Again, not our base case in the long run, but a possible scenario.

Secondly, term premium. Now, this is the yield premium which is embedded in nominal yields, and which should compensate investors holding longer-dated bonds. Now, this premium has been negative for quite some time now. Currently it is at -0.35%. Should investors now start to demand a higher term premium, given inflation uncertainty or faster Fed tapering?

Now, this could potentially lead to higher nominal yields. Now, by how much it’s difficult to say, but the average of this term premium in the last 20 years was 1%, and the average deal in the last 10 years 0.3%. So, you know, 60 basis points to 130 basis points additional surge on top of a fair value could be a result. Now, we also say, having said that, now we also need to think of a scenario of a pandemic-induced setback, or distress spill over. Omicron and China distress have been drivers of safe-haven flows lately, bringing yields back.

Now, a scenario leading yields back to the lows seen in 2020 seems very unlikely, but the lows at 1.17 seen this summer are not completely out of the world. Remember, yields retreated in summer, and that was caused by concerns over the Delta variant. Now we have Omicron, which is unlikely going to be the last variant. Yes, vaccines help, but it only requires a virus which is more immune to a vaccine to bring rates suddenly back to the recent lows.

Overall, our base case scenario looks for two, if not three, hikes in 2022. After the Fed turned more hawkish, there will be a gradual approach, then followed to what’s the neutral rate over 2023/2024. But again, this neutral rate, in our view, seems to be more below 2%, rather than far above 2.5%.

HP: Well, Michel, thank you for your insights today. The path of policy normalisation will certainly have widespread implications, not only for the economy, but also, of course, for investors. We’ll certainly be analysing developments very carefully over the coming days and weeks.

Let’s move on to the week ahead. Along with the MPC and the Federal Reserve, the other central bank meeting in focus will be the European Central Bank on Thursday. The Governing Council will discuss the recalibration of its monetary policy tools in light of its new macroeconomic projections, which will be extended until the end of 2024.

We’ll have to consider the trade-off between near-term downside risk to growth, which we’re expected to be reflected in a 50 basis point downgrade to its 2022 GDP growth forecast, and the upside risk to inflation with an upgrade to its 2022 projection of more than 100 basis points.

Moreover, we expect the stark macroeconomic projections to point to headline inflation at, or close to, the target 2% level at the end of the forecasting period. Recent statements from the Governing Council members have highlighted the very high uncertainty around these projections, and the need for being flexible, and not pre-committing too far ahead in terms of policy measures.

We think the Governing Council will confirm the end of net purchases under PEPP in March, with a slower pace of purchases in the first quarter of next year, and will scale up its asset-purchase programme with an additional envelope of €180 billion available until September, so watch out for details on that.

But with that, we’d like to thank you once again for joining us. We will, of course, be back in the New Year with our latest instalment, but for now may I wish you every success in the trading week ahead.