Morgan Stanley: Central Banks Are Increasingly Comfortable Pushing A More Hawkish Line… Until Something Pushes Back
By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley
We hope everyone had a Happy New Year and a restful holiday. It feels like we’ll need it. Right out of the gate, 2022 is greeting us with a surge in Covid cases, 199K on payrolls, geopolitical risk, and hawkish Fed communication. Buckle up!
Amid these issues, the question for our readers is whether the carefully crafted Outlooks and Investment Committee conclusions from late last year still hold. We think the main themes of our 2022 Outlook still apply – solid growth and tighter policy within an accelerated cycle. But clearly, there are now more moving parts.
One of them is the growth outlook. Our 2022 expectation was that global growth remains above-trend, led by DM and aided by a healthy consumer, robust business investment, and healing supply chains. Can that still hold with the new Omicron variant?
For the moment, we think it can. Our economists note that global GDP has become less sensitive to each new Covid wave as vaccination rates have risen, treatment has improved, and the appetite for restrictions has declined. Modelling by our US biotechnology team suggests that cases in Europe and the US could crest within 3-6 weeks, meaning that the better part of 2022 lies beyond this peak. With some form of ‘winter wave’ already baked into our original forecasts, we don’t think, for now, that the story has changed.
However, there are some wrinkles. Because China is pursuing a different (zero Covid) policy from the US, Europe and Japan, its near-term growth may be more impacted than that of other regions. And the emergence of this variant likely reinforces another prior expectation: that US and eurozone growth exceed EM growth in 2022.
A second wrinkle is the Federal Reserve’s hawkish shift. Last January, the market assumed the first Fed rate hike was still 40 months away (~April 2024). Last August, the market assumed liftoff would come around April 2023. Today, pricing implies that the first hike is ~2.3 months away (March 2022). Importantly, the Fed is doing little to suggest that these assumptions are wrong.
And this week it continued to push the story. A hawkish set of minutes noted active discussion around whether to raise rates sooner, raise them faster, and start shrinking the balance sheet (QT) much closer to the first rate hike than the market had anticipated. This last point is especially critical, given the importance investors have assigned to Fed purchases for overall market strength and resilience.
Our economists expect more details at the next Fed meeting later this month. But the direction of travel appears clear: 2022 will be a year of policy tightening.
And of course, it’s not just the Fed. At the time of writing, markets imply about 100bp of rate hikes over the next 12 months in the UK, 139bp in Canada, 245bp in Mexico, 150bp in Poland and 145bp in New Zealand. Japan stands out as the only major economy without a rate hike priced in for the next year.
Indeed, it would seem for the moment that central banks are increasingly comfortable pushing a more hawkish line until something pushes back. And so far, nothing has. Equity markets haven’t fallen, credit spreads are steady, and yield curves have steepened over the last month (the opposite of what you’d expect in a policy mistake). Why stop now?
For markets, therefore, our strategy still leans into the idea of a more hawkish tone to start the year. Our FX team remains bullish on the US dollar, while our US interest rate strategists remain negative on duration, especially in real rates. We think that this combination should be negative for gold but supportive for financial stocks, both in the US and around the world.
Elsewhere in equities, the expected rate hikes from the Fed and EM central banks, relative to the ECB and the BoJ, lead to different assumptions about how valuations in these markets evolve. We think that valuations for European and Japanese stocks, which are now similar to January 2017, are reasonable, and don’t need to de-rate further. US and EM equities, in contrast, face more valuation uncertainty ahead of the full force of the tightening cycle. In credit, tight spreads and shifting policy drive forecasts for modest spread widening, although low default rates should still support exposure at the bottom of securitized capital structures.
2022 is set to be an action-packed year, and one that looks likely to test many assumptions about how far, and how fast, monetary policy could shift in this cycle. We wish investors the best, even as they continue to see hawks.
Enjoy your Sunday.