Bedrock’s Newsletter for Friday 5th November, 2021

Posted by Honey Soleymani on 5th November 2021

Friday 5th November, 2021

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Risk assets have continued the impressive run they have been on since the correction in September and it seems that the seasonal Q4 rally – typically culminating in the “Santa Claus” rally over the last week of December – is well underway. Over the last two weeks (as of yesterday’s close), the S&P 500 was up +3.0%, the tech heavy NASDAQ was up +5.7%, and the STOXX 600 was up +2.4%. This leaves those three indices up +8.8%, +11.8%, and +7.2% respectively when compared to the troughs in early October. The S&P 500 has now been up for 15 of the last 17 days! Quite the run-back.

This performance has been driven by two main forces, both of which we discussed in our last newsletter. Firstly, we are now near the end of the Q3 earnings season and, all things considered, it has been a strong one. As of the end of last week, 56% of S&P 500 companies had reported earnings and 84% of these had reported positive EPS surprises (courtesy of FactSet). It is worth noting that the upwards revision in EPS has (so far) been the smallest it has been in the post-pandemic era and have been concentrated in the energy, materials, and financials sectors – all industries that are heavily geared towards higher interest rates and inflation. At the same time, the technology sector has reported earnings largely in line with expectations and the industrial sector, which has been most acutely affected by supply chain disruptions, suffered meaningful downgrades. This simply reflects all of the dominant market narratives – namely that the economic recovery is slowing and we are entering a higher inflation and interest rate regime – but a solid earnings season has clearly reassured investors. On the topic of equity markets, we think it is worth highlighting that the rally this year has been driven by earnings improvements rather than multiple expansion. Indeed, US companies are now cheaper (based on trailing 12-month P/E multiples) across the board than they were at the start of the year, with this effect particularly apparent in the small cap space. So while caution is still warranted as valuations are high by historical standards and certain parts of the market are approaching (or are already in) bubble territory, one would also be foolhardy to dismiss the fact that corporate America is making money at a record rate. Food for thought, whatever your view on current valuations.

The second driver is a familiar one – interest rates. We are now coming to the end of central bank meeting season and a non-exhaustive list of meetings over the last fortnight includes the Fed, ECB, BoE, and the BoJ. We will try to get through as many as possible.

We will actually start this segment with reference to two central banks not on that list, and certainly not ones that usually surface in discussions of global monetary policy – those of Australia and Canada. Last week, the Bank of Canada surprised markets by calling an end to its QE programme much earlier than expected (halting net purchases of government bonds), raising its inflation expectations, and signalling that they expected to raise rates sooner than they had previously indicated. The market quickly priced in a full 5 hikes by the end of 2022, 3 more than were anticipated prior to the meeting, and the Canadian 10Y yield rose 20bps overnight. At the same time, the Reserve Bank of Australia failed to defend the 0.1% yield target for its April 2024 bond, which caused the Australian 2Y yield to increase from 11.5bps to 77.5bps throughout the week. The RBA did completely abandon this yield target at their meeting this Tuesday, but most of the repricing was already done at that point. Despite being relatively minor banks in the context of global financial markets, these announcements only reinforced investors’ concern that inflation could force central banks to tighten policy faster than expected and sent short end rates upwards across the board.

Given this, investors were a bit nervous heading into the ECB’s meeting on Friday last week, but it turned out to be something of a non-event, much to everyone’s relief. The ECB held their policy rate steady and Lagarde highlighted that the ECB was planning to roll back its PEPP in March next year, a firmer commitment than had been given beforehand but still largely anticipated. She did specify that the ECB expects inflation remain higher for longer, importantly dropping the phrase “largely temporary” from the description. This suggests a more hawkish outlook, but Lagarde also pushed back on the market’s current pricing of future interest rates, saying that lift-off in 2022 or shortly thereafter is unlikely. It was a similar story for the Fed’s meeting on Wednesday as Powell adhered closely to the script, although he did follow in the ECB’s footsteps by acknowledging that inflationary pressures look less transitory than before. Nonetheless, there was no surprise rate decision and Powell simply announced that the Fed would begin to taper its asset purchase programme in mid-November as communicated, reducing its purchases of US Treasuries and agency MBS by $10bn/month and $5bn/month respectively. At this rate, the stimulus programme will come to an end in June 2022. Bond markets barely reacted to the meeting, but it seemed that equity investors breathed a collective sigh of relief that there were no nasty shocks and we saw a rare post-Fed meeting rally in the S&P 500.

There was a bit more excitement at the BoE’s meeting yesterday. Prior to the meeting, markets had nearly fully priced in a hike in November and were expecting the end of QE to be announced. There was little reason to doubt that this would be the case as these expectations were the result of a statement made by the Governor of the BoE, Andrew Bailey, just two weeks prior. His exact words were, “We at the Bank of England have signalled, and this is another such signal, that we will have to act.”. And so, it came as quite the surprise when the MPC voted 7-2 in favour of keeping the policy rate on hold (Bailey himself voted in favour of this) as well as 6-3 in favour of keeping QE running. It was doubly surprising given these votes coincided with an upwards revision of the BoE’s inflation outlook, which now expects CPI to peak at 5% in April next year. Now, they did highlight that they expect inflation to fall below target at the end of their forecast period, downgrade the growth outlook, and mention that a hike would be necessary within the next few months if the data was in line with projections, but the disconnect between the prior communication and the actual decision was stark. We suspect that any further attempts from Bailey to guide markets will be received with some scepticism. In the meeting’s aftermath, we saw yields on 2Y and 5Y Gilts fall 20bps, as well as a rally in global bond and equity markets in expectation of “looser for longer” monetary policy.

That wraps up the more interesting events of the last two weeks and we would like to leave you with a few important takeaways. Firstly, central banks are clearly re-assessing their previous assumptions that inflation is transitory and the general consensus is now that some pressures will be embedded for longer. Secondly, the bond market has been slightly too aggressive over the last month with respect to the pricing of interest rate hikes. Central banks have made it clear that higher short-medium term inflation is not sufficient on its own to trigger a tightening of monetary policy. There are many factors that will affect inflation and committee members are aware that the delayed impact of monetary policy decisions could cause more harm than good if it coincides with a drop in demand. Government support schemes are still being rolled back and the longer-term effect of this is hard to assess, particularly with respect to the workforce. Labour market data – such as the bumper US jobs report today – will be a key area to watch in the coming months.