LAWRIE WILLIAMS: Illogical equity price movements last week
It is impossible to comment here without reference to the passing of Queen Elizabeth II and the accession of King Charles III to the UK monarchy. I am old enough to remember the death of the previous monarch and the seamless transition which ensued – the benefit of a constitutional monarchy. This latest transition looks to be being equally seamless with King Charles vowing to continue to reign in a similar manner to his ‘dearest mama’. Queen Elizabeth proved to be a remarkable head of state respected throughout the world, with most other heads of state seemingly in awe of her – perhaps with the exception of Nelson Mandela, another truly remarkable leader.
Queen Elizabeth’s death after 70 years as UK head of state truly marks the end of an era and has seen huge changes with which her position always remained relevant – more so than any other monarchy. But life goes on and we are now in the midst of a global economic crisis brought on initially by the Covid pandemic and exacerbated by President Putin’s invasion of Ukraine and the perhaps unintended consequences of Western economic sanctions on Russia and the latter’s response in kind.
We commented here before that perhaps observation of the Chicago Mercantile Exchange (CME)’s Fedwatch Tool, which predicts the market’s view of the likely new interest rate imposition at the next FOMC meeting, would be a worthwhile predictor of likely equity market movement. The thought here had been that the higher the likelihood seen of a more elevated interest rate rise, the greater the prospective fall in equity valuations. To us the logic of this was inescapable. Businesses had become used to easy money and low interest rates helping prop up profits. If an aggressive Fed were to change course from its earlier QE and near zero interest rate policies the equity markets would surely dive.
Imagine our surprise then that over the past few days we saw the highest probability yet in the Fedwatch Tool – 91:9 – in favour of a 75 basis point rate increase over a 50 basis point one, yet equities and bitcoin rose – illogically in our view - and the dollar indexes fell when one might have expected the reverse to have happened. We think that further reflection over the weekend may well see a reversal, but the markets have a tendency to be optimistic and they may well have come to terms with the expectations of higher interest rates ahead and are now seemingly prepared to live with them – but for how long this mood will persist is anyone’s guess.
Inflation is, and is likely to remain, the key here. Fed chair Jerome Powell effectively repeated his Jackson Hole Symposium message in a speech to the Cato Institute last week saying: “It is very much our view, and my view, that we need to act now forthrightly, strongly, as we have been doing, and we need to keep at it until the job is done”. Doing the job means cutting inflation back to what we still see as an out-of-reach 2% target rate.
He went on to say that one of the main lessons from the 1970s was the Fed's pre-Volcker failed attempts to bring inflation under control. “The public had really come to think of higher inflation as the norm and to expect it to continue, and that’s what made it so hard to get inflation down in that case ... the longer inflation remains well above target, the greater the risk the public does begin to see higher inflation as the norm and that has the capacity to really raise the costs of getting inflation down.” Plus ça change!
Powell’s message was supported by statements over the past week from a number of other Fed members so there is little doubt that a continuingly aggressive policy is likely, leading to a year-end rate of up to 4%, maybe higher, unless of course data before then shows inflation coming down substantially.
The next such data release will be that for the Consumer Price Index (CPI) mid next week and this may well show a decline in the headline year-on-year inflation rate, but it will be the core rate which should be the most relevant – and we don’t expect this to fall much, if at all. Markets may take a lead from any possible fall in the overall rate, but this should probably be ignored. Oil and food prices appear to have fallen a little which will have helped improve the headline rate but not the core.
What the Fed’s aggressive rate policy will lead to is the increased likelihood of a U.S. recession, which should adversely influence markets worldwide. It would most probably reduce U.S. equity valuations and one would expect it to knock the bitcoin price too. Higher interest rates could have a positive effect on the dollar index, but this would, along with the rises which have already taken place, start to affect the competitiveness of U.S. exports and drive down import prices, thus raising the country’s current account deficit and its already dire debt position. This would eventually start to eat into dollar currency parities and reverse the dollar index rises, which should have a positive effect on gold and silver prices.
All this depends, of course, on the inflationary pressures remaining in place, and these are likely to do so as long as the Russia/Ukraine conflict continues which could be for some considerable time. The West continues to support Ukraine with training and modern weaponry, and Russia seems equally determined to press on with its invasion and is escalating the situation by limiting/cutting off energy supplies to Europe as well as ramping up the anti-NATO rhetoric. Ukraine may be making some military gains for now, but in the overall scheme of things they are small with Russia having gained around 20% of Ukrainian territory. If Ukraine is to succeed in its aims the war could be a long one indeed and the global economy will continue to be affected long term.