How US is becoming less attractive vs other markets
US: A slowdown in the US is inevitable after rapid GDP growth of 5.7% in 2021, but buoyant labour market conditions and further run-down of excess savings should still ensure that the economy registers a robust expansion of 3.5% this year and 2.3% in 2023. Inflation has continued to overshoot expectations and with the risk of second round effects refusing to go away, the Fed is set for lift-off in March. We expect it to raise rates four times this year, to 1.25%, with another 75bp of hikes to a terminal rate of 2% in 2023. The Fed is also likely to start shrinking its balance sheet in the fourth quarter of this year.
Eurozone: Growth is forecast to slow but remain high at 3.3% for 2022 and 2.6% in 2023. Households are expected to reduce their savings rate to more normal levels, and activity gets a boost from government spending as the EU recovery fund kicks in. Annual inflation is forecast to rise from 2.6% in 2021 to 4.2% in 2022, before falling back to 2.1% in 2023. However, the ECB remains dovish, ending PEPP in Q1 2022, but maintaining pre-pandemic QE until Q1 2023, and only raising rates in H2 2023.
UK: Growth should slow from 7.5% to 4.3% in 2022 as the boost from re-opening the economy begins fade. Household spending remains high as excess savings are reduced, but inflation reduces purchasing power. CPI inflation is forecast to rise from 3.6% in 2022 to 5.6% in 2023, mainly driven by higher energy prices. Inflation is then forecast to fall back to 1.7% over 2023. Meanwhile, a strong labour supports the BoE in to continuing to hike, taking the base rate to 1.25% by Q1 2023. Lower inflation and fiscal tightening lead to a pause for the rest of the forecast.
Emerging Markets: Most EMs have so far taken the hawkish pivot in global monetary policy in their stride, and solid external positions coupled with relatively high interest rates should continue to offer some buffer as the Fed tightens the screws. However, while these solid fundamentals should prevent an EM crisis, growth is still set to slow as fading impetus from exports to developed markets and higher domestic interest rates start to bite.
Our view remains that Fed interest rate hikes will likely begin this week with a 25 basis point (0.25%) increase and then three to four more rate hikes at subsequent meetings in 2022. Moreover, we think the Fed will start to reduce its nearly $9 trillion balance sheet in the second half of 2022. There is a risk to the upside (in hikes) depending on the trajectory of inflationary pressures. If consumer price pressures moderate over the course of the year as we and the Fed expect, then we think the Fed can take a more gradual approach to interest rate hikes. However, if inflationary pressures remain stubbornly high and we start to see longer-term inflation expectations become unanchored (more on this below), the Fed may be forced to move more aggressively than what is even already priced in.
HAS THE FED LOST CONTROL OF THE INFLATION NARRATIVE?
Inflation expectations are informative about how the current inflation experience has shaped the public’s views regarding future inflation. And the Fed pays close attention to how these expectations change over time. De-anchored inflation expectations tend to make further inflationary pressures self-fulfilling. So, it’s notable that the Fed’s January Survey of Consumer Expectations (the most recent one available) showed a decrease in short and medium-term inflation expectations. While still elevated, falling consumer expectations about future consumer price increases is encouraging. Moreover, longer-term market-implied inflation expectations are in line with historical averages. It seems that, despite the elevated inflation readings we’ve seen over the past few months, markets and consumers still expect price pressures to abate, which could allow the Fed to take a more moderate approach to interest rate hikes.
WILL FED RATE HIKES INVERT THE YIELD CURVE?
One of the big risks associated with Fed rate hikes, though, is when the Fed funds rate is pushed higher than longer-term Treasury yields. In this instance, the yield curve becomes inverted, which means shorter maturity securities out-yield longer maturity securities. Generally, the opposite is true and the yield curve is upward sloping. The slope of the yield curve is an important economic gauge, as an inverted yield curve has presaged every recession since the 1970s (though not all inverted yield curves have been followed shortly by recessions).
The Fed’s ability to substantially raise interest rates before yield curve inversion has been trending lower over the last few decades. Because the 10-year Treasury yield has been in a secular decline since the mid-80s, the Fed’s ability to raise short-term has been constrained. That said, we’re likely to hear more in the coming months about yield curve inversion and, thus, increased recessionary risks. And while it’s true that the Fed has never started a rate hiking campaign when the yield curve has been this flat (as seen in Figure 2 as measured by the difference in yields between 10-year and 2-year U.S. Treasury), the more important tenors on the yield curve, at least in terms of presaging recessions, are the three-month and 10-year yields, which are still far from inversion. As such, we believe the Fed has room to raise interest rates before true inversion takes place.
Central banks and their assessment of economic conditions will likely be front and center once again.
We expect the global economy to grow by 4.3% in real terms in 2022. This is less than the 5.8% we expect for 2021 but higher than the growth rate before the pandemic. In equities, we expect high single-digit returns in 2022 compared to double-digit returns in 2021. Government bond yields will likely move higher on the back of economic growth momentum and policy normalization in 2022.
My conclusions and considerations
- International or not, we have seen that inflation is not transitory, and we have many paper where we see how the central banks could be more aggressive or less on hiking rates.
- We also know how interest rates and inflation could impact the dividend’s policy about the firms, and as showed to the first chart of this article we understand that the risk/reward opportunities are not present in the US at the moment.
- The Central Bank should hike rates four times this year, to 1.25%, with another 75bp of hikes to a terminal rate of 2% in 2023. The Fed is also likely to start shrinking its balance sheet in the fourth quarter of this year.
- There is a risk to the upside (in hikes) depending on the trajectory of inflationary pressures.
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.