At the high-profile Jackson Hole Federal Reserve Symposium at the end of August, Fed Chairman Jerome Powell already gave first hints that the US central bank will soon adjust its ultra-expansive monetary policy and begin what is known as “tapering,”, or in other words to reduce quantitative easing (QE). However, this does not mean that the Fed will reduce its balance sheet, but merely make less additional liquid funds available to capital markets. Investors are now expecting the Fed’s tapering process to begin in the coming weeks. This, however, is conditional on a continued positive development of the US economy. While the timing and the foreseeable speed of the tapering had been roughly expected, the Fed nevertheless surprised at its monetary policy meeting last week, stating that an effective turnaround in interest rates, or a first rate hike, could be expected earlier. The Fed's roadmap sees a slow increase in the Fed’s key interest rate is expected up to 2.5% by the end of this rate hike cycle. However, eight out of 16 members of the Federal Open Market Committee (FOMC) are already of the opinion that the Fed should deviate from its quasi-zero interest rate policy as early as December 2022. The bottom line is that the Fed's current communication was a bit more “hawkish” than had been expected.
As the Fed set a new course the path for the capital markets is likely to become a little rockier, but not much more. Economic growth is likely to be above potential next year in both the United States as well as in Europe. Leading indicators in the G10 countries peaked in the summer, but continue to signal solid expansion, which reinforces our constructive fundamental view. Medium- to long-term inflation expectations in the US are still far from the danger zone of 3% or more, ranging from 2% to 2.25%. Thus, the credibility of central banks, first and foremost the Federal Reserve, seems to remain intact.
The risk factors for capital markets have actually diminished in recent weeks. For example, the corona pandemic is now seen as a “manageable” problem. However, a slowdown in the economic recovery in China, possibly also as a result of the problems surrounding the Chinese real estate group “Evergrande,” could become a challenge in the short term. At least for now, a domino effect is not expected, as the investment grade segment in China has hardly reacted to the swings in high-yield bonds triggered by Evergrande. Rather, it is a matter of an abrupt cooling in China's real estate market, which is after all responsible for more than 15% of China’s economic output. As a result, some economists have already reduced their GDP estimates for China.
For the Federal Reserve it will be a delicate balancing act to wean the financial markets off quantitative easing and to trigger the first interest rate steps in less than 18 months. The Fed is likely to aim to complete tapering by summer 2022, i.e. to reduce the purchase program from the current USD 120 billion per month to zero. Although the effect of this process cannot be dismissed out of hand, we should, so to say, leave the church in the village. On the one hand, the Fed’s monetary policy of remains expansionary, and on the other hand, capital markets continue to be supported by the QE programs of the European Central Bank and the Bank of Japan.
As we enter the final quarter, equities and commodities remain in focus and should be favored over bonds and liquidity. Despite increased volatility, investors will not be able to avoid equities, in our view. The equity risk premium for the S&P 500 remains above 300 basis points and profit margins have never been this high in the last 40 years. However, the Fed's tapering may well make the path rockier for financial markets. In early November, however, seasonality should be historically supportive. We remain positive on commodities in the portfolio context, as we believe prices in the current environment are driven by limited supply and less by the demand side.
In our equity strategy, we downgrade both Europe (ex-UK) and the United Kingdom to “neutral” to selectively realize gains. The valuation discount of Europe to the US and the global equity market is no longer so attractive that we can justify an overweight in the short term. Across assets, we continue to stick to a “barbell strategy” on a global basis: on the one hand, we focus on growth companies that benefit from long-term trends such as digitalization and, on the other hand, on cyclical quality companies that benefit from global economic growth.
The example of “Evergrande” shows once again that in the current environment it hardly makes sense to take major risks on the fixed-income side. Investors should take them on the equity side, if desired. With the start of the tapering process, the long end of the US yield curve should move slightly up towards 1.75% in the ten-year range. We maintain our neutral duration positioning. Within a fixed income portfolio, we continue to favor hybrid bonds as well as emerging market bonds in local currencies. However, selection in all categories remains crucial, as we recently witnessed in the short-term market turmoil in China.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Head Research & Strategy, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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