The Thanksgiving celebration marks the start of the festive season, but erratic moves in financial markets are creating the impression that investors are already thinking about next year. Questions about the nature of inflation and the US Federal Reserve’s stance in 2022 are paramount, helping to explain why volatility has been rising in government bonds. Another Covid wave (the fifth!) is troubling Europe in particular. Despite these factors as well as re-emerging geopolitical tensions, we believe the economic scenario remains favourable.
Markets have faced an intense flow of news in recent days, from the release of oil from the US Strategic Petroleum Reserve to a possible dovish shift in Chinese monetary policy. Analysing these developments would require a full article per topic, but for the time being, the effects on markets have been limited. Below, we discuss what we think are the most decisive factors for the coming months.
The pandemic again
The rising number of new Covid cases and the threat to hospital capacity are forcing a growing number of governments in Europe to take new restrictive measures. Bond markets have reacted: The prospect of a lockdown in Austria, confirmed over the weekend, contributed to a fall in the yield of the 10-year German Bund to -0.34% from -0.22% early last week.
The fifth wave also weighed on stocks. At the close on 24 November, European equities were down by 2.5% (EuroSTOXX index) from Wednesday a week earlier. The US S&P 500 fared slightly better closing up 0.3%, just below the record high set on 8 November.
Growing expectations of a more hawkish turn in the Fed’s monetary policy partly explained the stronger US dollar (+14% for the DXY index from 18 to 24 November) and underperformance of emerging equities (-2.6% for the MSCI Emerging index in US dollars against -0.9% for the MSCI AC World from 17 to 27 November).
What’s on the Fed’s mind?
US President Joe Biden’s reappointment of Jerome Powell as Fed Chair and of Lael Brainard as Vice-Chair should be approved without great difficulty by the Senate. Opting for continuity in combination with the appointment of a policy dove should please investors. However, both appointees have emphasised how damaging inflation could be for purchasing power, thus appearing to relay Biden’s message that “Inflation hurts American pocketbooks, and reversing this trend is a top priority for me”.
The minutes of the Fed’s 4 November monetary policy meeting, which decided on the tapering of asset purchases from this month , revealed that “some participants would have preferred a somewhat faster pace of tapering that would result in an earlier conclusion to net purchases”.
The policy-setting committee also insisted that the criteria for raising policy rates were much stricter than those that justified the tapering. The committee did not appear to question the need to be ‘patient’ in the face of bottlenecks that will continue to constrain supply in the coming quarters. On other occasions, however, current and former Fed members have said that they consider the current level of inflation as too high.
In fact, given the acceleration in inflation (+4.1% in October for the Fed’s preferred core Personal Consumption Expenditures Price index), expectations have strengthened that the reduction of the Fed’s asset purchases will be accelerated and key rate increases will come sooner and more frequently in 2022.
Exhibit 1: Market expectations now call for three US rate increases in 2022
In addition, recent economic indicators have generally exceeded market expectations, suggesting a rebound in GDP growth in Q4. Despite the decline in consumer confidence, personal consumption spending was particularly strong in October (+1.3%) thanks to higher disposable incomes.
A great year-end for the global economy?
Although the tightening of Covid measures across continental Europe has worried equity investors, this time the effects on economic activity are unlikely to be deleterious.
As the French statistics office writes in its economic outlook: “Having followed the epidemiological curve for a year and a half, French economic activity shifted away from this profile this summer as a result of the vaccination campaign.” Many of the recent measures are aimed at accelerating vaccination rates and, in particular, the booster vaccinations before winter.
November business surveys were encouraging. The rebound in manufacturing Purchasing Manager Indices in the eurozone, the UK, the US and Japan stands out. It could mark a first step in bottlenecks normalising. December data will show whether this trend can also be seen in emerging economies, while in Asia, the first signs of a recovery in manufacturing activity have already appeared.
Exhibit 2: Manufacturing activity is improving in developed economies
Services data is sending a more mixed message, often due to the pandemic and other sources of uncertainty. In France, the services PMI returned to its highest in almost four years and the INSEE business climate index improved in all sectors.
In Germany, the IFO business climate index fell in November for the fifth consecutive month. Supply difficulties in industry, and in particular the car industry, have pulled the index to its lowest since April. Encouragingly, Social Democrats (SPD), Greens and Liberal Democrats (FDP) have agreed on a coalition, lifting policy uncertainty and paving the way for a boost in business and consumer confidence.
So many questions for December
A new consensus now appears to have been established among investors: Inflation is transitory, but will remain higher for longer than expected. Opinions differ on what this means, including among central bankers.
As for the ECB, the debate on a possible increase in key rates looks less pressing than for the Fed, but the 16 December council meeting will likely be just as important for markets as the Federal Open Market Committee meeting scheduled the day before in Washington.
In Frankfurt too, opinions on the conduct of monetary policy are starting to diverge. It is about defining the terms of asset purchases after the end of the Pandemic Emergency Purchase Programme, expected for next March.
The negotiations appear tough and it is not certain how President Christine Lagarde will be able to answer questions such as what programme to replace PEPP with and what are the conditions for resuming purchases.
‘Peripheral’ bond markets could suffer from these uncertainties as significant bond issuance awaits in early 2022.