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The monetary policy statement of the January FOMC meeting yielded little surprise for us, with the Committee reaffirming the timing of the end of asset purchases and rate liftoff.
The monetary policy statement of the January FOMC meeting yielded little surprise for us, with the Committee reaffirming the timing of the end of asset purchases and rate liftoff.
The asset purchase programme i.e., quantitative easing is expected to end by March. The Federal Reserve noted “it will soon be appropriate to raise the target range for the federal funds rate” which Chairman Jerome Powell indicated during the press conference to be March.
The Fed also released a set of high-level principles for reducing the size of its balance sheet, noting that “the Committee expects that reducing the size of the Federal Reserve's balance sheet will commence after the process of increasing the target range for the federal funds rate has begun”. This and Powell’s comments put the plausible start of quantitative tightening around May-July.
There is, however, upside risk to the trajectory as Chairman Powell’s statements during the press conference took on a hawkish tone.
He did not rule out the possibility of the Fed hiking successively at consecutive meetings this year and emphasised that the no decision had been made and that “the economy is in a very different place” relative to the start of the previous rate hike cycle in 2015.
Chairman Powell also discussed the considerable uncertainty around inflation and how monetary policy needs to be able to address an outcome “where inflation remains higher”. He also said the FOMC would move “steadily” away from its current highly accommodative stance.
We expect the Fed will raise interest rates by 25bps per quarter this year, starting in March, and we expect the reduction of its balance sheet to commence in May.
The risks of more than four hikes this year would be premised on how inflation evolves: We currently expect inflation to peak around the middle of year and believe that the Fed remains in control of its inflation mandate with inflationary expectations staying relatively anchored. This is aligned with the relatively muted responses in inflation break-evens and the longer end of the yield curve.
History shows that post-recession equity bull markets do not end with the first hikes of the interest rate cycle. Looking ahead, we see significant scope for volatility and a structural rotation to cyclical and value sectors, and we believe that the broader post-Covid equity bull market remains intact, given a still constructive global growth outlook.
The US economy grew by 6.9% annualised (consensus: 5.5%) in the last quarter of 2021 relative to 3Q. This translated to 5.5% year-on-year (YoY) growth in 4Q21 and 5.7% for the whole 2021. The positive surprise came from a much higher level of inventory accumulation in the last quarter, which contributed 4.9%-pts. Consumer spending grew by 3.3% annualised, which was stronger than 3Q’s 2.0%, but was softer than what the market expected. We continue to believe the US will continue to grow above-trend at 4.2% in 2022, for the second consecutive year. The real economy remains in a robust position despite the ongoing rates volatility.
The drag from Omicron is spilling over to 2022, but we believe it will not be protracted given the experience in the US and UK. The number of new Covid-19 cases in the US and UK are falling quite rapidly; the 7-day moving average in the US has fallen from the peak of ~800k in mid-January to ~550k as of 28 January. In the UK, the same number has halved from the peak of 180k at the start of this year to ~90K after one month. The number of deaths in the UK has held level at a low rate compared to the worst in early 2021, but continued to rise in the US.
Outside of the US, 4Q21 GDP reports are mixed due to near-term Omicron effects. Germany contracted sequentially by -0.7% due to the restrictions of non-vaccinated residents and continuing supply chain disruptions. Bellwether Asian economies of Taiwan and Korea fared much better, growing by 2.7% and 1.1% quarter-on-quarter in 4Q21.
In terms of PMIs, while the sequential momentum was negative, all the readings remain at or above the expansionary level of 50. The latest flash PMIs for developed markets indicated declines across both manufacturing and services in the month of January. Services fell quite significantly from 55.2 in December to 50.4 in January, while manufacturing slipped from 54.9 to 51.0.
In our asset allocation strategy, we remain overall overweight in equities but move our preference from US equities to Asia ex-Japan given relatively more attractive valuations and risk-reward. This is achieved by moving Asia ex-Japan from market weight to overweight, and by moving US equities from overweight to market-weight.
We also move our position in Hedge Funds from market weight to over-weight as we believe that increased dispersion in bottom-up investment performance will benefit market neutral alpha-seeking fund strategies, and to further benefit from added diversification in our asset allocation strategy.
In fixed income, we move our position in Emerging Market High Yield (EM HY) bonds from overweight to market-weight given the anticipated headwinds from rising yields and a muted outlook for the Chinese property sector.
In our view, the outlook for EM HY has become more challenging. The re-pricing of the US interest rates outlook has set up a more challenging backdrop for EM HY, with the rate trajectory being more aggressive than previously anticipated. The outlook in the Chinese real estate sector, which is the biggest exposure in EM HY, has also been muted. There is no doubt that policy support is turning accommodative in China, as we have seen from the reduction in interest rates and bank reserve requirements. However, consumers, financial institutions and onshore investors remain quite cautious, and credit flow to weaker parts of the real estate market has remained limited, triggering more defaults or debt extensions.
With property sales in China likely to remain soft, more measures and policy fine-tuning to ease credit and capital crunch are necessary before we turn more positive.
Lastly, the increased geopolitical tensions (e.g., Russia/Ukraine) are expected to pose some drags on the market. We continue to maintain market weight positions in developed market (DM) HY and underweight positions in investment grade (IG) in both DM and EM.
Outside of the real estate sector, however, we remain broadly confident of the China economic outlook this year. The first rate cuts by the PBOC since April 2020 to the 7-day reverse repo and the medium-term lending rates are clear signals that the authorities are turning a lot more accommodative.
This will help to spur more local government lending, which would help support capital investments and infrastructure spending necessary to replace the investment gap from the slowdown in the property sector.
Total social financing, which has already ticked up in December, will likely get another boost from the rate cuts announced. Industrial production in December accelerated to reach 4.3% YoY, and Chinese exports continued to perform, expanding by a robust 20% YoY. Several of the drags to the economy like supply-side issues and slow fiscal spending are expected to reverse, and will turn more supportive of growth this year.
Importantly, valuations of Chinese equities are undemanding, especially when compared to the US, which points to significantly more attractive risk-reward. The 12-month forward price-to-earnings for China is close to its 10-year average while that for the US is 1-standard deviation above.
This combination of the turn in macroeconomic backdrop and attractive valuations suggests relatively more attractive risk-reward in Chinese equities in 2022, which underpins our shift in overweight positions in equities from the US to Asia ex. Japan.
Marquee internet platform names like JD.com, Meituan and Alibaba are currently trading at -1 to -2 standard deviations below their average five year historical price-to-sales ratio, and forward price to earnings are also ~0.5 standard deviations below historicals (Alibaba is much lower).
In China, the financials and materials sector are expected to benefit from the cyclical turn taking place over 2022 while renewables and new energy vehicles are multi-year investment themes that will remain important areas to watch.
Selected internet and platform companies remain on a long and bumpy but nonetheless directionally positive path towards regulatory clarity and earnings recovery.
Lastly, with the emphasis on the welfare of the lower- and middle-income groups under common prosperity, consumption demand will be supported, especially as restrictive Covid-19 policies ease. Consumer staples and selected consumer discretionary like autos should remain core holdings.
The long-term policy focus on common prosperity, carbon neutrality and the careful management of credit and leverage will remain key for companies and their performance.
This article was first published by Bank of Singapore on Jan 31, 2022. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates.
OCBC NISP Private Banking provides a suite of products for wealth creation, preservation and transmission including holistic wealth management services, independent research, customized solutions for all investor preferences, and genuine open architecture, with expertise in Indonesia and Asia Pacific markets. OCBC NISP Private Banking is a part of OCBC Group.
