Financial update from Brewin Dolphin 8 April 2022

April 2022

The Weekly Round-up

Friday 8 April 2022

In this week’s round-up, Janet Mui, our Head of Market Analysis, discusses the minutes from the Federal Reserve’s March policy meeting and the latest sanctions on Russia.

Equity markets are experiencing a renewed sell off as bond yields continue to grind higher amid more hawkish Federal Reserve communications.

Fed balance sheet reduction

On 5 April, Fed heavyweight Lael Brainard said the Fed “will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce its balance sheet at a rapid pace as soon as our May meeting”. Following that, the official Fed minutes from its March meeting revealed its plan to reduce its bond holdings ($9trn) by $95bn per month, at a maximum monthly pace of $60bn in Treasuries and $35bn in mortgage-backed securities. This equates to a more than $1trn balance sheet reduction in a year. That is double the pace of the previous balance sheet reduction in 2017.

The minutes also showed that many officials would have favoured increasing interest rates by half a percentage point last month, but deferred to a quarter percentage point increase in light of Russia’s invasion of Ukraine. They viewed one or more half percentage point increases as possibly appropriate going forward if price pressures fail to moderate.

Market expectations have shifted dramatically. Compared to the beginning of the year, the market now expects 200 basis points of extra rate hikes over the next 12 months. This could potentially mean the biggest annual increase in the US Fed funds rate since 1994. The Fed is clearly behind the curve and is now scrambling to accelerate tightening.

Markets stabilised toward the end of the week as investors digested the Fed’s balance sheet reduction plans and the yield curve steepened after inverting. It is unclear how long the steepened yield curve can stay, given that front-end yields can still rise while long-end yields may price in a recession as the Fed puts a brake on growth. That said, balance sheet reduction plans may technically drive long-end bond yields higher.

Sanctions

Aside from the Fed, investors continued to monitor the developments in Ukraine as Western governments widened sanctions. A milestone was reached when the EU said it would begin targeting Russia’s energy sector, with a ban on coal imports worth an estimated €4bn a year. Companies would be allowed four months to wind down contracts before being banned from entering new ones. The fifth sanction round also includes a ban on most Russian trucks and ships entering the EU. Still, the EU is holding back from sanctioning Russian oil and gas given its heavy reliance on these. There will be further discussion among EU members about energy sanctions, but it is unlikely they will reach a consensus.

Regardless of what happens, it is clear that the war is having a negative impact on Europe particularly, through continued high natural gas and electricity prices. But the impact will be felt by consumers globally, as the invasion has also kept oil prices higher than they otherwise would be, which is weighing on real wages. High energy prices also contribute to higher inflation. In addition, the fact that China is sticking to its zero-Covid policy in the face of its worst wave since the crisis began risks slowing the improvement in supply bottlenecks, and slowing the rate at which inflation pressures subside.

Cautious view

With the debate on Russian energy sanctions ongoing, intensified inflationary pressures, higher interest rates, the squeeze on consumers, labour shortages and a greater probability of recession, we think it makes sense to be more cautious in our macro views and positionings.

This month, our Asset Allocation Committee reduced the size of our equity overweight in risk category six by 2%, downgrading proportionally across all six of our equity regions to maintain a broadly neutral exposure. This will still leave us with a small overweight in equities.

We put the proceeds equally into cash and absolute return. The global equity market remains off its January highs. Notwithstanding the renewed weakness of the past two days, there has been a solid rally over the past few weeks, which provides an opportunity to sell into. Also, the European VSTOXX index of implied volatility remains elevated, but it has also declined substantially over the past month. It is never ideal to sell into a panic, so the fact that conditions have normalised somewhat also indicates a more attractive selling opportunity. We believe putting part of those proceeds into cash can provide dry powder when markets correct more substantially.