Friday 17th December, 2021
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Here in Europe, Christmas is almost upon us; and, on the face of it, there is very little out of the ordinary about this year’s holiday season. Fairy-lights sparkle through steamy windows, tinsel is slung over every naked banister, pictures of a tubby, white-bearded man have spread like wildfire, and squat trees stand in living rooms everywhere, adorned with kitsch toys and shiny baubles. On the Day itself, families are looking forward to familiar plates of mince pies, huge slabs of turkey, buckets of champagne, relentless board games, and the inevitable row across the dining room table when someone mentions that they are starting to miss Donald Trump.
However, the festive season has brought no respite from the pandemic this year, and anxiety about the spread of the Omicron variant is palpable beneath the surface. The UK has become something of a test case for how countries with high rates of vaccination and few restrictions will suffer this latest variant… and the sheer speed at which Omicron has spread is astonishing. Cases are doubling every two days, and Omicron is now dominant in London (despite the first infection having been identified just three weeks ago). In addition, there is now good evidence that Omicron can escape vaccines – until someone has had their booster shot, at least – and, at the same time, there is growing hope that Omicron causes fewer deaths and hospitalisations than Delta. This means that governments have even less idea than normal about what they should do, and the stakes are very high. We could be in for the worst covid-19 winter yet or a relatively good one. Either way, we will know soon enough. All eyes will be on the UK in the next few weeks.
Despite the spread of the Omicron variant, and given the danger posed by mounting inflation (discussed in these pages many times), the Fed decided to push ahead with tapering its vast QE programme this week; indeed, the US central bank now plans to increase the pace of stimulus withdrawal in the coming months. QE has been essential to support markets during the past two years of heightened uncertainty. But it worked rather too well… and with growth and inflation having rebounded sharply this year, there is now a consensus that the programme needs to end (soon) so it does not start to do more harm than good. When tapering began in early November, the Fed was buying USD 120bn worth of bonds each month, a truly phenomenal injection of liquidity. It now expects to have reduced bond purchases to just half this level by the end of the year; and, from January, it will cut purchases by a further USD 30bn each month going forward. This means that the whole QE programme could be wound up by the end of March, months ahead of schedule.
What is more, the US central bank seems to have done a 180 degree turn on interest rates, from being ultra-dovish to being quasi-hawkish. All 18 members of the Federal Open Market Committee (FOMC) that sets US policy rates now expect there to be at least one hike in 2022, and the majority expect there to be three in total before year-end. This reflects a transformation in thinking at the Fed, which had once stressed the transitory nature of inflation and had hoped to keep rates at zero for several years to avoid choking off the post-lockdown recovery. For its part, the market has now fully priced in the first interest rate hike by June next year. But, with inflation rising fast, a March move cannot be ruled out.
Of course, whether (all) these rate hikes materialise will depend on the course of the pandemic. We are not out of the woods yet, and we expect the Fed (and the government) to err on the side of caution in the event that Omicron hospitalisations get out of control. But the shift in approach at the Fed shows that Chair Powell has finally woken up to the risks posed by soaring prices. Just this week (if we needed another reminder), the November reading for US producer price inflation came in at +9.6% YoY amid ongoing supply chain disruption! This is not a sustainable pace of change. There may be some flexibility around the 2% average inflation target, but such readings can only be ignored for so long.
The Bank of England has also turned more hawkish this week, raising short-end policy rates for the first time since the pandemic began (albeit by just 15bps). As discussed above, the UK has found itself on the sharp end of covid-19 once again this Christmas. But the central bank believes that the new variant is likely to make little difference to the UK’s medium-term outlook – and that inflation is thus the greater threat. We continue to favour UK stocks over other regions, given their cheapness on most long-term metrics; and the decision to hike rates in the UK sits well with our preference for value in this market.
But, although the Fed and BOE are changing tack, this is not the case with all central banks around the world. The ECB, for example, has so far stuck to its more cautious approach to stimulus withdrawal and rate hikes. To be sure, it has said that it will phase out the emergency asset purchase programme (i.e., the PEPP) in March. But, at the same time, the ECB plans to boost another purchase programme to pick up some of the slack. This means that while bond purchases will slow from EUR 80bn today to EUR 40bn in April, there will still be considerable liquidity on offer next year. And the ECB has ruled out rate hikes while QE is still in effect.
For investors, then, there are several conclusions to draw from the latest policy pronouncements. Firstly, adding interest rate duration in fixed income is not a smart move right now. Higher short-end rates and a less favourable technical environment across the curve (as QE is wound down) are likely to drive negative returns for longer bonds in the coming months. Secondly, so-called ‘meme stocks’ which are over-owned by retail investors should be avoided at all costs. The party is not over for these companies (and their vast marketing departments) – that will only come when central bank balance sheets begin to shrink – but the punch bowl is not being refilled at quite the same speed. In other words, the clock is ticking. Thirdly, one should maintain a high level of portfolio diversification across sectors. Higher rates suggest that high growth stocks will not be so attractive going forward; and, while equities may continue to climb across the board, discounts can also close (and quickly). Finally, dollar assets look like a good place to park money right now. The USD-EUR and USD-JPY rate differentials are likely to rise next year if central banks follow through on recent guidance, and this will provide a tailwind for the greenback in our view. Moreover, if Omicron turns out to be a disaster, the dollar is likely to benefit from its safe haven status… Uncle Sam can win both ways. We would not bet against him.
Please note that this will be our final newsletter of the year. We hope you enjoyed it. The next instalment will be on 7th of January 2022. In the meantime, we wish you all a very happy and relaxing holiday!
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