|January into February has been a wild month for money markets. Equities went from hitting record highs at the beginning of January to falling into ‘correction’ territory with double-digit losses, only to come back through the beginning of Feb.
These wild swings in the market are, of course, against the backdrop of a significantly shifting economic landscape and continued uncertainty as Covid continues to throw up new challenges.
For markets, the three big stories lie in:
- The removal of quantitative easing
- Interest rate hikes (it started with NZ, the bank of England followed suit, and the Federal Reserve have now appeared to telegraph their first-rate rise (more on this below); and
- The removal of fiscal spending that economies have enjoyed over the past couple of years.
In isolation, any one of these things would cause market movement but put them all together, and volatility is certain.
Experts remain at odds in judging if markets have yet peaked, but they have certainly enjoyed the incredible liquidity ride since the GFC (now 13 years ago). Today and as a result of the higher inflation numbers, things look set to become more challenging.
Quantitative Easing (QE)
As we’ve previously commented, the inflation issue is predominantly a supply-side issue. We now know that people in lockdown (particularly when stimulus is involved) tend to have an insatiable demand for physical goods. So, as just-in-time manufacturing tries to meet the demand of global lockdowns, supply chains struggle. These channels are now healing but probably won’t return to 2019 levels easily. We are starting to see new orders falling in the PMI surveys and inventories building which is encouraging, but the world is not there yet, and it is causing some policy reaction from central bankers who are now receding away from the policies that were designed to get us through the pandemic.
Now that vaccination targets have improved, more people have had Covid (particularly offshore), and Omicron appears to be less severe; we hope that the worst of the health crisis is behind us. This doesn’t mean we discount the danger of new variants or further restrictions; however, the QE policies of 2020/21 are no longer fit for purpose, and equity markets are having to come to terms with this.
Interest rate hikes
We have the inflationary issue, yes the issue is predominantly from the supply side, which we’ve ascertained won’t dissipate for some time. However, central banks can curb demand and that will have an impact on economic activity and in turn, quell inflation.
The world is tremendously interest rate sensitive; we have gorged on low rates for some time now (in Australia, 36% of spending goes on debt servicing). We probably won’t need to turn the interest rate lever far in order to change people’s consumption habits.
Politics! Looking to the US who are coming into their midterms (back half of 2022), the moderate Democrats are starting to consider their re-election viability and, in doing so, are starting to break away from the more hardened left. What this means is Biden, who in the past has had a paper-thin ability to pass legislation in the Senate via reconciliation (at 50/50), will begin to find these endeavours more and more challenging (for instance, ‘Build Back Better’ is seemingly now dead in the water – harpooned by a single West Virginian Senator). And so, some of these fiscal programs that would probably result in quite heavy inflationary outcomes may begin to recede away.
From a market perspective, there is a lot to navigate. In our view, 2022 with the combination of little to no QE, some rate hikes (potentially more than markets are currently suggesting) and the withdrawal of fiscal spending will have a big impact on the potential for volatility.
It is important to remember however, that volatility and market corrections are very normal.
For example, the US stock market has dropped at least 10% (on average) every 11 months for the last 100 years.
We read somewhere this week that if someone predicts a 10% (or more) decline in the stock market, they’re really just stating:
“Everything is normal and this happens, on average, every 11 months.”
~ Morgan Housel