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Inflation and Monetary Policy – In this article let’s see:
- How the economy is changing
- How Energy and Utilities are performing
- Who are the most expensive sectors
- How strong is the US economy
- How the dollar appreciation is behaving and how inflation could change
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Enjoy the article
Inflation and Monetary Policy
The US has exhibited exceptional resilience to the crisis, and a strong labor market continues to drive economic growth this year, despite building inflationary pressures. Europe on the other hand has been fully impacted by the conflict and faces a significant growth deceleration in 2022. Likewise, in China, where the pandemic continues to proliferate despite a ”Zero Covid” policy, our growth forecast for 2022 has been revisited downwards.
Both the European Central Bank (ECB) and the Federal Reserve (Fed) were late to react to mounting inflation, the former more so than the latter, and the war has complicated the path toward policy normalization. We expect rate hikes and quantitative tightening to continue, although at a slower pace in Europe compared to the US.
Inflation continues to be the key theme driving portfolio construction. Equities remain in favor, particularly in the US where earnings growth should stay positive amid a more resilient economy. Here, investors should however avoid the names most exposed to higher rates, and look at value and quality segments in the search for opportunities. The ability to preserve margins will be critical especially in H2 and 2023, and company pricing power will be key in this respect. Strong and fast movements in the bond market calls for a tactical approach to duration, now not as short as a few weeks ago. The short part of the curve now seems particularly appealing as it has already priced in most of the Fed hiking cycle, while the long end will likely reprice further. US housing related securitized markets may be particularly attractive in light of a strong housing market.
Macro: US growth continues to hold steadfast
The US economy has proven to be exceptionally resilient in the current context. We’ve witnessed strong GDP growth in the fourth quarter, mainly stemming from inventory accumulation, with consumption running a little weaker. Due to material inflationary pressures we can expect some softening in consumption. Energy prices are up significantly YoY, likewise housing, and these hikes are likely to dampen consumption.
On the other hand, US consumers are in better shape than they were prior to the pandemic. High savings rates are complemented by a very strong labor market characterized by worker shortages, 11 million job openings and less than half that number unemployed.
Macro Strategy – Global Growth Weakening Fast, Fed On Track To Make Matters Worse:
The escalation of the Ukraine/Russia conflict has caused growing worries about the prospects for world peace, food and energy supplies, global growth, and financial market conditions. Heightened risk aversion has resulted in a typical flight to the safety of the dollar, once again frustrating dollar forecasts with a significant upside surprise as the conflict intensified.
The dollar appreciation has sharply slowed the commodity price rally, and lowered expectations for the manufacturing Institute for Supply Management (ISM) Index as well as the corporate revenue and profits outlook, given their typical correlation. This, combined with the biggest inflation shock to the U.S. and Europe since the 1970s, and the Federal Reserve (Fed) outlining an aggressive monetary policy tightening campaign in response, has sharply diminished the outlook for global growth and profits in 2023.
High input prices, such as for energy, can be inflationary or deflationary depending on how monetary policy responds. Up until now, with the U.S. money supply growing at the fastest pace since War World II (WWII), policy has been highly accommodative of rising input prices. Ultra easy monetary policy has kept demand for energy strong, for example, and has allowed price increases to be passed through, creating inflation across the spectrum of goods and services. Profit margins have held up as a result of this ability to pass through high input prices.
That is changing now, as liquidity conditions tighten with central bank around the world raising interest rates. The dollar surge in recent months is a sign that dollar liquidity to pay for the doubling of the world’s energy bill is becoming strained as the U.S. base-money supply begins to shrink. Countries that import food and energy, where prices have surged, are seeing sharp deterioration in their current account balances that are putting downward pressure on their currencies and forcing them to use their dollar foreign-exchange reserves to plug the gap. In contrast, the U.S. and other food, energy and commodity exporters are seeing relative currency strength.
Fed Talked the Talk, Walked the Walk
There were some changes to the FOMC’s post-meeting statement. What stood out is the phrase that Fed policymakers are highly attentive to inflation risks—a hawkish stance. There is a long list of inflation risks, including lockdowns in China, Russia’s invasion of Ukraine, and its impact on energy and food prices. Also, the U.S. labor market is tight.
The FOMC also announced the runoff of its balance sheet beginning on June 1. The initial pace is $47.5 billion per month, but after three months that will increase to $95 billion. This isn’t a gradual increase; the September rise will be sudden. To start, the runoff is $30 billion for Treasuries and $17.5 billion for mortgage-backed securities. The Fed has a ton of Treasury securities maturing over the next several months giving it the opportunity to be more aggressive on the reduction in its balance.
If the Fed sticks with its current plan, its balance sheet will decline by about $520 billion this year. This may sound like a lot, but the balance sheet will still be massive, around 37% of nominal GDP. It was less than 20% of nominal GDP before the pandemic. And there was no mention of MBS sales.
We noticeably altered our forecast for the fed funds rate in our April baseline, but another change could be needed in May. The effective fed funds rate is now forecast to average 2.1% in the fourth quarter, compared with 0.9% in the March baseline. The FOMC may get rates to 2% sooner than in our baseline by hiking 50 basis points at each of the next couple of meetings. The terminal fed funds rate, or where rates peak this cycle, is now 2.75%, 30 basis points higher than in the March baseline and will be hit nearly a year earlier than in the March baseline.
My conclusions and considerations
US growth marginally revised down and set to remain above DM level in 2022.
The US depends less on Energy imports then it used to.
The economy is changing, we’re seeing high inflation, the FED has begun to hike the interest rates, commodities always up and the superdollar that seems don’t stop anymore.
Energy and utilities stocks were the main outperformers in the first quarter, as oil and gas prices rose and investors sought defensive plays.
Financials continued to have the cheapest valuations at the end of the first quarter, ranking as the least expensive sector by price-to-earnings and price-to-book ratios. The most expensive sectors were consumer discretionary, utilities, and industrials.
- Inflation continues to be the key theme driving portfolio construction. Equities remain in favor, particularly in the US where earnings growth should stay positive amid a more resilient economy.
- The ability to preserve margins will be critical especially in H2 and 2023, and company pricing power will be key in this respect.
- The US economy has proven to be exceptionally resilient in the current context.
- Due to material inflationary pressures we can expect some softening in consumption.
- High savings rates are complemented by a very strong labor market characterized by worker shortages, 11 million job openings and less than half that number unemployed.
- The dollar appreciation has sharply slowed the commodity price rally, and lowered expectations for the manufacturing Institute for Supply Management (ISM) Index as well as the corporate revenue and profits outlook, given their typical correlation.
- High input prices, such as for energy, can be inflationary or deflationary depending on how monetary policy responds.
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.