Financial Update from Brewin Dolphin - 4 November 2022

November 2022

The Weekly Round-up

Friday 4 November 2022

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses the market’s reaction to rate setting in the US and the UK, and the potential for a relaxation of China’s Zero Covid strategy.

Slower but higher

The big event this week was the Federal Open Market Committee meeting, which saw the Fed hike the federal funds rate by 75 basis point for the fourth time, bringing the upper bound of the target rate to 4%.

The Federal Reserve was at the end of the day perceived as hawkish even though it guided for a slower pace of rate increases as soon as December. The statement that accompanied the rate included a new sentence that said the Fed would take into account both the cumulative tightening of monetary policy and the fact that there are lags with which monetary policy impacts the economy and inflation.

The market initially read that as dovish and as a signal that the Fed was likely set to slow the pace of tightening at its December meeting. However, that market judgement changed at the press conference. Fed Chair Jay Powell pushed back against the idea of premature rate cuts (markets were pricing in a Fed “pivot” of two 25 basis points rates cut by December 2023) and emphasised again that the risk is doing too little rather than too much. Specifically, he signalled the federal funds rate will need to be higher than what the “dot plot” previously indicated (4.6%).

Hence, markets have adjusted the peak US rate expectation to be a bit over 5% in mid-2023 with the Fed keeping rates at those restrictive levels throughout 2023. We know the Fed wants peak interest rates to get higher than previously thought (albeit reaching that via a slower pace of tightening), but there is a lack of clarity over how high that will go. On the economy, Powell said the window for avoiding a recession has narrowed. Since the labour market remains strong, more tightening would be needed to cool the (over)heating, and a recession is more likely than not in the journey to bring inflation down.

Strong jobs report but some cracks

It is that time of the month again where all eyes are on the US nonfarm payroll report, as investors are trying to work out how high US interest rates will peak, after the Fed Chair said they need to be higher than previously pencilled in. Overall, the jobs report was strong, but it did start to show some cracks in sectors that are interest rate sensitive.

A total of 261,000 jobs were created in October, which well exceeded expectations and continued the strength of the previous months. However, the unemployment rate climbed from 3.5% to 3.7% as a separate household survey showed a weaker employment picture. Average hourly earnings rose +0.4% MoM which was higher than expected, while the YoY rate slowed from 5.0% to 4.7%. Labour force participation declined which would be seen by the Federal Reserve as unhelpful for slowing wage pressures.

There were, however, pockets of weakness which are more affected by interest rate rises. The job level in the real estate and rental sector, which has been hit by higher mortgage rates, fell by about 9,000 in the month, the biggest decline since the start of the pandemic. Overall, the nonfarm payroll report is still consistent with a strong labour market, which will keep underlying inflation sticky. This means the Fed will stick to its hawkish stance and keep delivering more rate rises in the coming months, albeit likely at a slower pace compared to the jumbo hikes seen so far. Market pricing of Fed funds rate is little changed post the jobs report. The market’s next focus will be on next week’s US inflation report.

A “dovish” hike

We saw contrasting developments from the Federal Reserve and the Bank of England (BoE), despite both putting up rates by 75 basis points as expected.

The Monetary Policy Committee was perceived as dovish despite putting up a jumbo rate increase, because it has explicitly pushed back against what markets were pricing in for Bank rate (quite unusually so). Typically, the Bank of England used “market interest rates”, which is its central scenario, as well as “constant interest rates” as assumptions to make its growth and inflation forecasts.

The “market interest rates” path that the BoE used was based on Bank rate reaching a peak of 5.25%, the data which was available a week before the meeting (which had already fallen from over 6% post mini-budget). Conditioned on this assumption, UK GDP will fall by almost 3% peak-to-trough with a recession lasting two years. In this scenario, headline inflation reaches 0% by end-2025.

Using “constant interest rates”, which is 3% Bank rate throughout the forecast horizon, peak to trough GDP fall will be 1.7% and the recession will last for six quarters, with inflation slowing to about 2% by Q2-2024. It is worth noting that even in the higher interest rate scenario, the BoE does not expect the recession to be particularly severe in magnitude compared to past recessions, which is a bit of good news amongst the bad news.

So, to take it at face value, there is no need to hike to 5.25% to get inflation back to 2% target. In fact, if the BOE raised rates to that level inflation would undershoot the 2% target in the medium term. So the key takeaway from the BoE Governor’s speech and the BOE’s forecasts is that UK interest rates will not need to reach 5.25%. Equally, it is unlikely to remain at 3%. So the peak rate is likely to be somewhere in the middle.

UK interest rates futures have repriced expectations of peak UK Bank rate to about 4.6% following the MPC meeting. It is important to note that the BOE has yet to take into account the “tough decisions” (austerity) anticipated from the Autumn Statement on 17 November. So these forecasts may change and so may the BoE’s ultimate view, and hence market expectations of peak UK interest rates. The divergence of interest rate guidance between the BoE and the US led to sterling weakening vs the dollar. The reason why the BoE is leaning a bit dovish is because the UK is much more interest rate sensitive than the US, and the UK’s economic position is weaker.

Next week, attention will turn from cause to effect as we see how the evolving energy and labour markets impacted US consumer price inflation during September. Retail sales data will also be published for the US and the UK, with some more employment data released for the latter on Tuesday.

Light at the end of the tunnel for China?

Speculation that China will relax its Covid Zero strategy led to the biggest weekly jump in the Hang Seng Index since 2011. Is that sustainable? Well, reopening is certainly great news, but so far there is no official statement that this is happening. The authorities have recently reaffirmed their commitment to Covid Zero and markets may be getting ahead of themselves.

Even if China does relax restrictions, the reopening process is unlikely to be smooth sailing. On that front, it is worth bearing in mind that the relative performance of Chinese company profits vs the rest of the world has been disconnected from its economic outperformance for a long time. The fact that President Xi is now even more unconstrained to enact policies that may not be so market friendly didn’t give us much confidence that this dynamic would change.

Aside from Covid Zero, investors are likely to remain concerned on the political and geopolitical implications after the cabinet reshuffle by President Xi at the National Party Congress. The tensions between the US and China, and China and Taiwan, will not go away.

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