Bassanese Bites: 2018 again? – December 20 2021

Global markets

The all-important Fed meeting came and went last week with global markets largely taking the more hawkish than expected tilt in their stride. Global equities retreated modestly, but bond yields actually fell over the week – with the latter perhaps still more concerned with the rapidly spreading Omicron variant.

The key news last week was the Fed effectively pencilling in three rate rises next year, compared to market expectations of only two. The Fed did accelerate bond tapering as widely expected, with the program now scheduled in March – which should pave the way for the first rate rise in May. The Fed have also pencilled in three further rate rises in 2023 – which all up means the mid-point of the Fed target rate range would rise from 0.1% at present, to 0.9% at end’ 22 and 1.6% at end ’23.

By my reckoning, U.S. 10-year bond yields under this scenario should reach around 2.25% by mid-22, compared to only 1.4% presently. If the U.S. S&P 500 forward PE ratio held steady around 20, it would imply a decline in the equity risk premium (or forward earnings yield less bond yield gap) from 3.4% to to 2.75% – or the low end of its range since the global financial crisis over a decade ago. Indeed, this yield gap was last seen in turbulent 2018, when sustained Fed tightening over several years had finally pushed 10-year bond yields over 3% and produced a decent correction in equity prices (the S&P 500’s PE ratio fell from 18 to 14 over the year even whilst forward earnings kept rising). Will history repeat itself? I suspect the odds of a decent equity correction – of at least 10% – are greater than 50%.

In other news, the Bank of England surprised markets by electing to hike rates – even as Omicron courses through the UK economy – due to a desire to ensure currently high annual core inflation of 4% is not embedded into expectations next year. The European Central Bank equivocated – pledging to end one bond buying program early next year while promising to keep buying under another program. Like the RBA, the ECB still thinks it won’t raise rates next year.

The key global highlight this week will be the Fed’s preferred inflation measure, the private consumption expenditure (PCE) deflator on Thursday. This is expected to show a further uncomfortable lift in core annual CPE inflation to 4.5% from 4.1%

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