Financial update from Brewin Dolphin 6 May 2022

May 2022

The Weekly Round-up

Friday 06 May 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the outlook for China and the latest US and UK interest rate decisions.

April was a weaker month for stocks but the volatility continued during the start of May as well. On everyone’s mind has been the prospects for interest rates. Inflationary pressure builds as demand exceeds supply and so the various factors that have been weighing on supply for the last year are really beginning to make their impact felt.

For investors, part of the conundrum is whether these short-term factors will reverse. Some of them surely will. The delay in shipments from China due to Covid restrictions has allowed the logistics market some opportunity to catch up, with freight rates dropping accordingly. Clearly that’s not universally good news, even from a supply perspective, as part of the reason for it is that Chinese factories aren’t producing as much. We expect China to be able to manage its Covid challenge by increasing vaccinations and eventually being able to relax lockdowns.

China

In the meantime, we expect to see policy support increasing with the objective of achieving a level of growth that is within a believable distance of the Chinese Communist Party’s (CCP) recently reiterated objective (5.5% for this year). The various levers that will accomplish that are familiar to Chinese investors. The People’s Bank of China has cut the reserve ratio requirement, facilitating the release of more credit to the economy which is resulting in an improving ‘credit impulse’. That has previously been a good sign for investors. The Chinese authorities are ramping up infrastructure investment once more.

One of the most controversial topics in China is the outlook for the large cap digital economy stocks that were once the darlings of global equity markets, but have had their wings firmly clipped by the CCP’s focus on “common prosperity” at the expense of shareholder value. Although there is no official let up in that prioritisation, the intensity should drop as firms are subjected to “normalised financial supervision”. The CCP has indicated that it wants this pressure to ease.

The benefits of a market which is desynchronised, and therefore not facing the same inflationary and monetary pressures as the rest of the world, are enticing and China looks more interesting now than it has done for a long time.

Supply side constraints

Of course, that has to be taken in the context of the overall global balance of supply and demand capacity. China’s growth and membership of the World Trade Organization increased global supply capacity materially, facilitating a long period of disinflationary pressure. 2016 increasingly looks like a high watermark for that, such that even once the cyclical and Covid-related constraints on supply ease, deglobalisation and decarbonisation are likely to keep the inflationary pressure simmering away and requiring policy restraint.

For that reason, the market remains anxious about the long-term level of interest rates and this week saw US ten-year bond yields cross 3%.

Federal Open Market Committee

Understandably, much attention is being lavished on interest rate setters in the current environment and we had two meetings this week which were not hugely informative in terms of the future direction of policy but managed to get pulses racing regardless.

The Federal Reserve meeting was remarkable in its lack of material shocks. The Fed raised interest rates by 0.5% and described the way in which ‘balance sheet run off’ would start in June at a pace of $47.5bn before accelerating in September to a pace of $95bn.

During the preceding weeks the most currently hawkish FOMC member, James Bullard, had refused to rule out the possibility of a 0.75% hike, raising much speculation about whether one might be hinted at for the next meeting. But Fed chairman Jay Powell confirmed it was not currently part of the committee’s thinking, triggering a sharp equity market rally.

Powell referenced the core CPI rate slowing in March to 0.3% month-on-month from 0.5% month-on-month in February. This is part of an essential judgement he has to make over whether higher prices are feeding into higher wages and vice versa, forming a so-called wage price spiral that can only be halted by aggressive central bank action. Adding to that was a reassuring set of employment data that showed a slower pace of wage growth despite a very healthy level of jobs growth. If this continues that will give Powell the confidence to slow the pace of rate hikes.

It wasn’t completely surprising that Wednesday’s rally, which had been fuelled by such modest revelations reversed on Thursday, although the speed at which it did so was certainly shocking. Ultimately there was very little information communicated. The US market continues to exhibit violent intraday swings which seems to be a function of increased retail participation via options.

Bank of England

When the Bank of England’s monetary policy committee (MPC) announced policy on Thursday, the details were again in line with expectations, with interest rates rising to 1%. However, the Bank’s forecasts caught the eye with a surprisingly high estimate of inflation hitting 10% in the final quarter of this year, at which point it expects growth to slow leading to an overall decline during 2023. These forecasts could imply a period of slow growth that occasionally dips into negative territory, but it seems more likely that the Bank is expecting a recession, without explicitly using the term Recession.

In that context, three members of the MPC wanted to raise rates faster, but another two members were reluctant to imply that there would be further interest rate hikes coming.

After digesting these forecasts and voting intentions, the markets decided that interest rates will not rise as fast in the UK as had been expected, causing bonds to rally and the pound to slump.