Locked & Loaded

MON 10 JAN 2022

In policy circles it is never accurate to say that something is a “done deal” but the direction of official interest rates over the next few months appears locked and loaded. Of course, the concept of monetary policy is much broader in this episode and the Fed has already signalled the taper of QE and the flagged the potential transition to QT (balance sheet run off). In addition, a couple of FOMC voters (Waller & Bullard) have argued for a March rate hike which is now largely priced in the December Eurodollar contract (chart 1). Indeed, approximately 4 rate hikes are now priced for the full year 2022.

While December’s employment data once again showed disappointing payroll growth, it continues to likely reflect a shortage of supply rather than insufficient demand for labour. By contrast, more stable measures of the labour market such as the unemployment rate are probably consistent with “full employment” and therefore inconsistent with policy conditions remaining at emergency levels. The big picture point for markets is that tighter policy is coming; with non-trivial implications for long duration growth entities that have benefited from the super-abundant liquidity regime. Tighter liquidity typically coincides with a rise in cross asset volatility.

From our perch, although the headline payroll growth disappointed on Friday, the unemployment rate slid to 3.9% and wage growth surprised on the upside. For context, the current unemployment rate is only 0.5% above the 1968 trough (chart 2). To be fair, labour force participation or the employment-to-population ratio is lower than peak conditions in 1999/2000. However, it is challenging to argue that the labour market is not now close to “full employment.” Perhaps the greatest challenge for the Federal Reserve is that although there has been an acceleration in nominal wages, the growth in consumer prices has led to a drop in real income. Stated differently, the rise in consumer price inflation to 7% (to be reported on Wednesday) probably leaves the Fed with no choice but to withdraw liquidity and hike rates at a much faster pace than had previously been anticipated by financial markets.

Looking further out, a key debate (we and others have noted) is whether more rapid tightening now implies a quicker end and lower overall magnitude to the tightening cycle. The short answer probably is “yes” but as we have also observed, the aggregate impact of policy tightening might be larger when viewed through the lens of the withdrawal of QE combined with nominal rate hikes. That is why the 2018 cycle felt more like 500 basis points of tightening rather than 225 basis points. Moreover, the Fed’s ability to implement a dovish pivot in this episode is likely constrained by a much higher inflation rate.

While there has already been a material (40-50%) correction in some hyper-speculative speculative growth equity since Q3 last year, the rally in MSCI World Value/Growth has been modest so far given the rise in yields (chart 3). To be fair, that likely reflects the more defensive nature of mega-cap US tech versus more speculative “growth” equity. However, the broader point is that there is likely still decent upside in value equity relative to growth, particularly if the monetary policy cycle is more aggressive than currently expected.

On the positive side, the risk is now more widely appreciated and there is has already been an adjustment in positioning and consensus beliefs. On the negative side, the MSCI US Technology index still trades at 8 times EV/Sales, equivalent to the peak in 1999/2000, while the more speculative growth equity trades at more than 10 times EV/Sales. On a cross asset basis it also highlights that long duration fixed income remains challenged as a diversifier for equities in this episode. A bigger adjustment in valuation and beliefs still probably lies ahead.