Bedrock’s Newsletter for Friday 23rd December 2022
Posted by Carlota Vandekoppel on
Friday 23rd December 2022
Last time out we wrote of markets’ lack of festive cheer – and registered our view that this was a fair reflection of the panoply of downside risks hanging over markets. Market moves in the fortnight since have confirmed this unseasonal funk and all major equities indices are on track for a brace of back-to-back down weeks. For a moment it did not look to be shaping up this way. Last Tuesday’s November CPI print offered plenty of reasons for cheer on the inflation front: the YoY number was 2022’s lowest and was below expectations, at +7.1%, while the MoM number (+0.1%) slackened to its lowest in 15 months. Importantly, this was the second downside inflation surprise in a row. Given the interpretation that this could allow the Fed to soften policy, the market response was – fleetingly – full-throated. By mid-morning in New York the S&P 500 was up +2.74% and 2Y and 10Y yields had fallen -21.6bps and -18.8bps, respectively. The stage appeared set for an early Santa Claus rally. Instead, markets quickly cooled and those numbers were a more desultory +0.73%, -15.7bps and -11.0bps by the closing bell – and the next day, instead of Santa, investors got Fed Chair Powell. As expected, 2022’s final FOMC meeting hiked a softer +50bps (rather than +75bps as at each of the previous four meetings) but Powell’s loud beating of the ‘higher-for-longer’ drum drowned out any positivity this may have encouraged. At his post-meeting press conference, Powell was unequivocal that the Fed still had work to do, so would keep on raising rates and hold them high until ‘substantially more evidence’ persuaded them that inflation had been contained. FOMC members’ ‘dot-plot’ projection for rates at the end of 2023 rose to a median 5.1%, up from 4.6% at the September meeting. This decidedly hawkish tone was echoed in Frankfurt the following day, when ECB President Lagarde declared rates would ‘still have to rise significantly’ (the ECB also hiked +50bps). Risk assets sold off: the S&P 500 was down -2.1% for the week (and a whopping -6.1% if measured from the intraday peak after the CPI print), while Europe’s STOXX 600 and Japan’s Nikkei were down -3.3% and -1.3%, respectively. The negative trend continued throughout this week. The central bankers were clearly determined to keep investors sober as the festive season approached – and to be fair, the stubborn belief in an upcoming Fed pivot had largely fuelled October and November’s gains, undoing some of the effect of the hikes to date. Powell repeatedly told the press conference that it was ‘important’ that financial conditions ‘reflect the policy restraint we’re putting in place’ and indicated no rate cuts until 2024. For now, markets are not buying this; futures are pricing in 2 cuts in 2023 and a Fed Funds Rate of 4.46% in a year’s time, well below the Fed’s projection.
Having allowed their European and American colleagues to hog the limelight last week, this week Bank of Japan (BoJ) officials grabbed attention by surprising markets. On Tuesday, the BoJ unexpectedly shifted the parameters of Yield Curve Control (YCC), the ultra-accommodative policy whereby the Bank sets a target for Japanese Government Bond (JGB) 10Y yields and uses theoretically unlimited sales or purchases to hold it in place. Outgoing Governor Kuroda Haruhiko announced a doubling of the +/-0.25% tolerance band either side of the BoJ’s 0% target for the JGB 10Y. The BoJ will now defend that 0.50% mark, the maximum yield it will allow JGB 10Ys to trade at. As central bankers elsewhere tightened financial conditions this year, the BoJ found itself an outlier – an expensive position to be in: it has spent tens of billions of dollars intervening in FX markets to prop up the yen, which has tumbled dramatically. Expectations – and market pressure – have been growing that something would have to give. Kuroda has been closely associated with YCC but his tenure ends in April 2023 and many market participants anticipated his successor would water down or end the policy – and perhaps even raise rates. But that is precisely why Kuroda was well advised to spring a surprise now (to be sure, something he has famously not been shy of doing). It is in the nature of YCC that had he signalled the move with any form of forward guidance, market pressure would have instantly forced the BoJ’s hand before they could have acted. This way Kuroda could choose his own timing, rather than being swept away by a wave of speculation. (It also smooths the path for his successor, rather than dropping them straight into a patch of nettles.) The move certainly gave markets a jolt: the yen surged +3.9% against the dollar, its largest daily gain in the 21st century, and the Nikkei stock market index dropped -2.5%. Reverberations were felt globally, as the latest ‘Kuroda bazooka’ sparked a selloff in global sovereign bonds (traders reasoned that rising rates domestically would encourage Japanese investors to forsake overseas bonds in favour of higher yields closer to home) and weighed on equities across Asia (Korea’s KOSPI and Australia’s ASX 200 fell -0.8% and -1.5%, respectively). For all Kuroda’s wisdom in moving without forewarning and his insistence that it represented neither a rate hike nor an end to YCC (maintaining it was rather an effort to iron out yield curve distortions and improve market liquidity; the BoJ holds more than half of outstanding JGBs and some days none change hands whatsoever), the genie seems to be out of the bottle. Markets have wasted no time waiting to probe the BoJ’s willingness and ability to defend the newly raised upper limit – which yields duly hit on Wednesday. Swaps markets are already pricing in a JGB 10Y yield of 0.80% and markets are betting further BoJ tightening will drive the yen yet higher. JGB 2Y yields even turned positive for the first time since 2015. Japanese core inflation reached a 40 year high of 3.7% YoY in November, appreciably above the 2% target. Although the BoJ line is that the current inflation is largely energy driven and thus transitory, the ex-food and energy figure was also above target, at 2.8%. With the annual shunto wage negotiations in the spring tipped to produce a +3% wage rise, helping entrench inflation, the way may indeed be cleared for Kuroda’s successor to normalise BoJ policy later in 2023.
Meanwhile, across the East China Sea, China is grappling with the fall-out of its own dramatic policy shift – though in this case public health, not monetary. On 7th December, covid restrictions were suddenly eased, most notably an end to obligatory centralised quarantine for mild cases and an abandonment of the ubiquitous health QR code app and the attendant testing (without which entry to public places had been impossible). This amounted to a dramatic, de facto end to the zero-covid policy that has kept the virus at bay – and normal life locked-down – for nearly 3 years. The Omicron variant of the virus is now sweeping through the populations of China’s major cities, unhindered by the kind of immunity built up in countries that have been more lax with earlier strains. One estimate is that over 40% of Beijing’s 22 million residents have been infected, while a leading Shanghai hospital expected over half of the city (home to 26 million people) will have contracted the disease before the end of the year. Videos are proliferating online of hospitals overwhelmed as patients receive treatment on the floor and of relatives queuing to collect urns from crematoria. Streets are reportedly largely empty and many businesses shut, with people either too ill to leave home – or preferring to shelter there in the hope of avoiding infection. However, we are unlikely to learn the true scale of the crisis: authorities have announced they will now only count deaths caused by respiratory failure induced directly by Covid-19, rather than any other underlying illnesses, and the country has stopped reporting hospitalisations to the World Health Organisation. The suddenness of the move and apparent lack of an exit strategy is remarkable – and troubling – given the years to prepare one, bought so dearly through some of the world’s most stringent pandemic controls. The cost has not least been economic, throttling the government’s much-touted efforts to rebalance the economy toward domestic consumption. It was the economic cost that finally forced reopening; on the eve of the loosening, the Politburo declared priority should be put on stabilising the economy, rather than fighting the virus. But anecdotal evidence of shuttered production lines and high-frequency data such as subway usage figures suggest reopening is so far hurting the economy. The boost for Chinese equities we noted last time has now reversed as investors have seen indications of the scale of the unfolding crisis. (Though, without wishing to be tastelessly morbid, we note that Hong Kong-listed burial and funeral service provider Fu Shou Yuan (China’s largest) rallied +10% in today’s trading.)
This is our last newsletter of 2022 – a year that has not wanted for subject matter when preparing these notes. There is time yet for that Santa Rally – traditionally dated to the final five trading sessions of the year, plus the first two in January – but we rather doubt the kindly gentleman will be making the trip down from the North Pole to spread market cheer this year. We will be back in the new year to report to the contrary if we are wrong. As we head into that new year, a host of questions hang heavily over markets. Will the much-anticipated recession hit – and if so, how fiercely, for how long, and where? Will inflation sink back to the levels of near dormancy seen in the last decades? Will central banks ease rates in light of potentially lower inflation and real economic pain? If they hold the firm line signalled this month, will this prove an astute staying of the course, or rather cause unnecessary damage? How will corporate earnings hold up? Can China’s economy rebound from the damage of both zero-covid and its sudden easing – especially in a world perhaps in recession? Might China’s monstrous Covid wave create a new, more potent covid variant that again threatens global economic life? Will companies look to shorten supply chains in favour of ‘friendshoring’ (to use the peculiar D.C. Beltway argot), eroding globalisation? How will the Russo-Ukrainian war progress? Will 2023 bring more such geopolitical shocks? We look forward to tackling these questions and many more in the new year – which we hope proves more benign for markets than its fast-fading forebear. In the meantime, we wish our readers a happy holiday season and a Merry Christmas!
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