Friday 18th March, 2022
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Despite the uncertainty caused by the Russian invasion of Ukraine, Fed policymakers went ahead with a 25bps interest rate hike this Wednesday, as expected. The decision to raise rates after nearly two years of unprecedented monetary easing was a long time coming. Inflation, globally, is now running at a pace not seen since the 1970s/80s, and it may yet surprise to the upside in the months ahead given the extent of the commodity price rises and financial and trade disruption caused by the war in Eastern Europe. US real rates are well below zero – and have been for many months already – despite healthy growth, negligible unemployment, and US consumers being in their best financial shape in years (which is not the typical backdrop against which the Fed starts to hike rates). The current policy mix is clearly unsustainable, central bank credibility is on the line, and Fed Chair Jerome Powell knows it. Indeed, the very large number of rate hikes that Fed officials proposed after this week’s meeting has a whiff of panic about it. Both Fed policymakers and investors (as implied by futures) now expect at least a further six rate hikes before the end of 2022, which would push the Fed Funds up to 1.75%! That is a big move in a short space of time; and, together with quantitative tightening (‘QT’), which is due to begin this summer, should help to cool the red-hot US economy and inflation.
Nevertheless, we think that there is a lot of room for error. The Fed is confident that the US economy can withstand higher rates – and said as much on Wednesday. But with so many hikes planned in quick succession, there will be very little new data to support each of these Federal Open Market Committee (‘FOMC’) decisions independently. There are almost certainly known and unknown ‘unknowns’ about the dynamics of the post-pandemic US and global economies, and therefore monetary regime change carries an outsized risk today. Unfortunately, with US consumer price inflation topping 7% right now, such risks must be taken (or else an inflationary death spiral will surely grip the economy). But it did not have to be this way. Last year there was widespread concern among policymakers (not only in the US) that doing ‘too much, too soon’ would stifle the global recovery after the collapse of demand in spring 2020. Misunderstanding how tight labour markets had become in the summer of 2021, the Fed failed to respond to price rises (which were deemed manageably transitory) in an effort to ‘play it safe’… That now looks remarkably wrong-headed. Still, better late than never.
Also hiking this week was the Bank of England (‘BoE’), which managed to lift its key policy rate to 75bps without crashing the car. Unlike the rest of Europe (or Japan), where there is little appetite to hike rates soon, the BoE is among the more hawkish central banks globally, and UK rates have historically been higher than those in most other countries. The UK is also one the markets that is least impacted by the war in Ukraine given its low dependency on Russian oil and gas. That is one reason why the FTSE 100 Index has strongly outperformed other European indices this year. Another is its tilt towards less rates-sensitive value/cyclical sectors, such as financials and materials. We have had a favourable view on UK equities for some time, given their relative value and macro sensitivities in the current environment. A more protracted war between Russia and Ukraine (God forbid) and/or inflation surprising to the upside could both spur further UK equity outperformance, we believe.
Beyond the catastrophic human toll of the war in Ukraine, which rises every day, there have been some more encouraging headlines since our last newsletter. In particular, both sides have put a positive spin on recent talks. Indeed, in the middle of the week, there were even suggestions that a ceasefire could be achieved within days and that a lasting peace deal could be negotiated shortly thereafter. This seems to have been untrue (or, at least, rather unrealistic). However, Russia has suffered major setbacks since the invasion began, and its forces are making slow progress due to myriad logistical failures. A war of attrition would cost the Kremlin dearly, and stiff Ukrainian resistance appears to have forced Russia to the negotiating table without the momentum that would have allowed Putin to dictate terms. Russia is upping the ante – shelling cities across Ukraine with increasing ferocity – but the Russian economy is tanking, and time is not on the Kremlin’s side. For his part, Zelensky has now accepted that NATO’s ‘open door’ is largely rhetorical, and so he seems willing to accept Ukraine’s formal neutrality in a future deal (a core Russian demand). But the status of Donbas and Crimea are a sticking point and could yet derail the talks completely. In another worrying sign, US intelligence agencies believe that Russia has requested military aid or assistance from China, and this could force the Middle Kingdom to finally show its hand with regards to Ukraine. The US has warned that any Chinese intervention will carry a heavy economic cost for the country. Meanwhile, China is experiencing the worst covid-19 outbreak since the pandemic began, with large cities such as Shenzhen in lockdown. The government is back in easing mode to prop up the economy and has announced that ‘market friendly policies’ will be introduced for technology and related sectors (which suffered last year on regulatory concerns but soared in the wake of the statement: Baidu and Alibaba both rose c.40% on the day). Therefore, President Xi would really rather not come to Putin’s aid right now. But events rarely come at the opportune time. And helping Russia now (at Putin’s moment of weakness) could pay geopolitical dividends down the line when the current conflict abates, and he is in Xi’s pocket. Where the war goes from here is hard to predict, but the longer it rages the more aggressive Putin’s tactics are likely to become – and the higher we can expect oil, gas, and other commodity prices to soar. In this environment, we continue to favour balanced exposure to commodities, alongside limited duration in fixed income, and a diversification of styles and sectors in equities.
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