Fed to start tightening its monetary policy: October 2021 Monthly Market Commentary
08 November 2021
MARKET CONTEXT: Fed to start tightening its monetary policy
Global Macro: As expected, the US Federal Reserve decided to start reducing its monthly bond purchasing program by US$15bn, which should trigger a moderate rise in long-term yields. On the other hand, other major central banks are expected to keep their target rates unchanged till the end of next year: ECB (-0.50%), BoJ (0%), PBoC (2.20%). We note global economic activity has been improving. In the US, the services Purchasing Managers’ Index (PMI) surprised to the upside, reaching a record-high level of 66.7 in October. In China, exports surged 28.1% YoY to US$305.7bn in September. So far, Evergrande’s partial default has been contained by the Chinese regulator and the PBoC and we believe a widespread contagion to other sectors of the economy is unlikely. Strong global demand has been driving commodity prices up, with oil prices rising another 10% in October and 70% in 2021, while natural gas prices doubled in 2021. On the pandemic front, we note the Delta variant has only had a moderate impact on global economic growth, which contributed to improved market sentiment.
Although the Fed started to tighten its monetary policy, we believe the US is unlikely to let their cost of funding increase much. Based on our econometric model, over the next 12 months, we expect to see the effective Fed funds rate (currently 0.08%) within the [0.10%; 0.50%] range, the 10-year US Treasury yield (currently 1.56%) within [1.4%; 2.0%], the 10-year German Bund yield (currently -0.18%) within [-0.3%; +0.2%], and the 10-year Chinese government bond yield (currently 2.95%) within [2.8%; 3.2%]. Global equities rallied in October, driven by strong earnings and increasing economic activity. Given anticipations of higher US rates, the USD has remained strong against most currencies, except the RMB, which strengthened c.1% in October. The RMB strength is supported by strong exports and interest rates that are much higher than in Western economies (short- and long-term yields close to 3%).
Equity:Month to date the S&P 500, Euro Stoxx 50, and Hang Seng Index gained 6.7%, 5.0%, and 3.3%, respectively, amid improved market sentiment. Fixed Income: The 10-year US yield further rose 4bps in October to 1.56%, underpinned by market anticipations of the Fed’s policy tightening; as a result, Emerging Market government bonds (-0.1% in USD; -1.6% in local currencies) and High-yield corporate bonds (-0.1% in USD; -0.4% in EUR) all went down. Currencies:With respect to USD: EUR -0.1%, AUD +4.3%; CNY +0.8%; safe-haven JPY -2.3%, CHF +2.0%. Commodities: Gold rebounded by 1.5% in September while oil prices further climbed 10.4%, fueled by strong global demand and insufficient supply.
Covid-19: New waves of infections caused by stronger Covid variants could result in new restrictions and lockdown measures around the world, with a strong negative impact on the economic growth outlook, although higher vaccination rates would limit the risk.
China’s regulatory tightening: Following the implementation of stricter regulations in both the tech and education sectors, Chinese regulators may target other industries, which would further impact financial markets.
Rising long-term interest rates: We expect central banks to start reducing cash injections and tapering their bond purchasing programs within the next 12 months, which will result in higher interest rates and downward pressure on equity valuations. Meanwhile, investors are requiring higher yields to compensate for the risk of governments’ ballooning debt.
US tech bubble & high US equity valuations: Tech stocks remain under pressure, given the highest valuations since the dot-com era and high market concentration, while the Biden administration is expected to take a much stronger stance on the tax and anti-trust treatment of tech companies.
US-China tensions: US-China trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. In addition, the US is maintaining pressure on Chinese companies listed on US stock exchanges by implementing stricter rules targeting Chinese firms.
Hedged bond income portfolios: As interest rates will likely trade in a range over the next 12 months, we highlight the importance of receiving positive carry (income from bonds or money markets) in fixed income portfolios with bond capital gains contributing less to fixed income portfolio returns. As the next move for rates is most likely on the upside, reflecting bond buying tapering from central banks, partial hedging of bond portfolios will be key to optimize risk-adjusted returns.
Chinese equities: The Chinese stock market has underperformed Western equities by c.40% this year amid US-China tensions and increased Chinese regulation on tech firms, with Chinese tech stocks plunging c.40% since January. However, we think the downside risk from here is moderate as the Chinese market starts to rebound and US hedge funds and asset managers are building long positions again.
Oil & Gas: The energy sector is a major beneficiary of the global recovery, while long-term anticipated oil demand remains robust. Moreover, we are seeing increasing interest from investors towards major energy players that are implementing green energy programs to transition from fossil fuels to clean, sustainable energy production, thus making them major decarbonization contributors.
Financials: We believe the financial sector will benefit from higher yields and a steeper yield curve when long-term interest rates eventually rise, but also from stronger growth via a reduction in nonperforming loans and the positive impact from lower loan provisions on earnings revisions. This would be positive for both the banking and the insurance sectors, where valuations continue to look attractive. We think stocks of well-capitalized quality banks in the US, Europe, Hong Kong, and Japan will pay above-market dividend yields following their central bank’s green light.
Chinese Yuan: The RMB reflects the forward growth of the Chinese economy and the increase in global trade and investments in RMB. The yuan is also becoming an important reserve currency for central banks and financial institutions, underpinned by China’s strong economic fundamentals: a large positive commercial balance, growing domestic consumption, and much higher interest rates than in Western economies. Moreover, China became the number one country in the world for Foreign Direct Investments in 2020 according to the UN, with growing inflows from investors buying Chinese stocks, bonds, and hard assets contributing to the strengthening of the renminbi and consolidating its role as a major trade currency.
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