Weekly Investment Update (09/23/2022)
- The Fed: The Fed hiked rates by 75 basis points and reiterated its hawkish stance; elevated inflation readings priced in a more hawkish Fed.
- United Kingdom (U.K.): Proposed tax cuts in the U.K.’s new economic growth agenda triggered sharp declines in bond yields and the pound as investors weighed the stimulative measures amid a backdrop of high inflation.
- Japan: Bank of Japan (BoJ) maintains status quo while the Ministry of Finance intervenes to strengthen the yen.
- Markets: Equity markets are drawing similar parallels to prior midterm election years so far in 2022; resolution to political uncertainty may be a constructive factor, yet more certainty around a slowdown in inflation and Fed hikes is needed for volatility to subside.
Fed Hikes Interest Rates 75 Basis Points, Reiterating Hawkish Stance
This week, the Federal Reserve unanimously voted to hike interest rates by 75 basis points in a move that was widely anticipated by markets. While Powell took a hawkish stance, his tone was very similar to the one he set forward in his speech at Jackson Hole. He highlighted that the Fed remains focused on restoring price stability, and to do so, rates must stay higher for longer. The dot plot now shows an additional 125 basis points in rate hikes this year versus the last time these estimates were published, with projections implying a 75 basis point hike in November and a 50 basis point hike in December. In the Summary of Economic Projections, the terminal rate was revised from 3.8% to 4.6%. While this is a significant upward revision, elevated tightening was priced into the markets. Prior to the meeting on Wednesday, the market had priced in a terminal rate around 4.5%.
Powell pointed to softening growth, stating in the press conference that a period of below-trend growth and slowing of the labor market will be necessary to bring inflation back to its target, and that policy needs to be restrictive as measured by positive real rates. Longer-term inflation expectations remain anchored, but Powell stated that is not grounds for complacency.
We are likely past the point of peak hawkish surprise and peak interest rate volatility. With a larger upward revision in the Summary of Economic Projections terminal rate, the markets did not rapidly reprice rate hiking expectations; they remained largely in line with expectations prior to the meeting. While the Fed will be mindful of slowing economic growth, we will likely not see a shift in policy without notable declines in inflation, but nor would we expect the Fed to signal a change in its intentions until it is close to shifting policy.
U.K. Tax Cuts Trigger Currency and Bond Selloff
On Friday, the U.K.'s new economic growth agenda shocked markets with the size of its proposed tax cuts. The proposed tax cuts look to amount to 1% of GDP, or roughly £45 billion, above prior expectations of closer to £30 billion, with the total cost of the tax cuts adding up to £161 billion over five years. The proposed tax cuts would substantially add to the U.K. deficit and would also be in breach of the Johnson administration's fiscal rules.
In reaction to this announcement, we have seen sharp moves higher in U.K. yields and a decline in sterling as markets reacted to the effects of fiscal stimulus amid high inflation. Inflation recently reached 9.9%, almost five times higher than the Bank of England’s target. Investors are now anticipating the central bank will increase the lending rate by 100 basis points to 3.25% in November. The pound moved below $1.11 for the first time since 1985. The spillover effect from the U.K. also further pressured U.S. markets as investors shed risk assets on Friday. Bessemer portfolios remain underweight the U.K. relative to respective benchmarks.
Bank of Japan Maintains Yield Curve Control While the Ministry of Finance Intervenes
Following the hawkish tone from the Federal Open Market Committee, the focus turned to the Bank of Japan led by Governor Kuroda. Kuroda maintained a dovish status quo while continuing to implement yield curve control (YCC) in Japanese Government Bonds (JGB). The framework for the YCC is a short-term rate of -0.1% and a 10-year JGB target of 0% with a 0.25% upper band. Kuroda’s tone was dovish as well noting that adjusting YCC would not be necessary for “two or three years.”
The immediate market reaction was short covering of JGBs, pressuring yields lower, but more importantly, additional weakness in the yen. The USD/JPY exchange rate traded close to 146 before the Japanese Ministry of Finance (MoF) intervened in the currency market. The last time policymakers intervened against yen depreciation was in 1998.
It is important to note that central bank policies have global impacts. The mechanics of yen intervention is that the MoF needs to sell U.S. dollars to buy yen. Official reserve assets, as of the end of August, state that the MoF holds around $1 trillion in securities and approximately $135 billion in cash/deposits. While the official size of the intervention will not be known until next month, we do not think it was more than its stated cash/deposits. Unilateral FX intervention is generally not successful, and therefore, anticipation of more currency management adds pressure to higher short term U.S. yields as investors anticipate U.S. dollar cash raising, perhaps through official sales of U.S. short-dated fixed income instruments.
Equity Markets: Interesting Parallels During Midterm Election Years
Historically, out of the four presidential years, midterm election years are the most volatile year for equity markets. The average intra-year decline for the S&P 500 is nearly 20% for midterm election years, notably higher than the 13% average for the other years in a presidential cycle. While the 2022 election year does not appear to be an exception to this historical pattern, we note that the S&P 500 has produced positive returns in the 12 months following a midterm election with a 100% hit rate since 1942. Furthermore, the average 12-month returns following midterm elections are 15%, versus 7% for all other years. Monthly seasonality has also followed historical patterns as of late. Looking back at monthly equity returns, September is the worst performing month of the year with late September proving to be an especially difficult period. Further, in analyzing monthly equity market returns during midterm election years, we can see that June and September are the worst months while October and November are unequivocally the best. For more details on market implications of midterm elections, please see our midterm election note.
There are many factors driving market volatility this year, and the fact that the resolution of political uncertainty may contribute to more constructive markets is just one factor we are considering. Federal Reserve policy remains the main focal point for stocks and bonds, and uncertainty around the extent to which the Fed will hike is the main driver of recent weakness in both asset classes. It will likely take greater certainty of slowing inflation and the Fed moving to neutral to see volatility subside in the coming weeks. Bigger picture, we continue to see equity earnings yields above 10-year Treasury yields as attractive. Further, investor sentiment that remains near the poorest levels in memory is a contrarian indicator.
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