Weekly Market Update: War Drives Market Sentiment

Mon 04 Apr 2022

Market Update

US stocks started the week strongly as reports appeared to show that a ceasefire deal, in which Ukraine would abandon its drive for NATO membership in exchange for security guarantees and potential EU membership, could be possible. However, the mood soured in the middle of the week as Pentagon officials cast doubts on reports that Russia was scaling back operations in Kyiv. Nevertheless, major indices in developed markets ended higher at the end of the week, with the US stock market ending +0.7% higher, the UK stock market rising +0.8%, and European stocks gaining +2.4% in Sterling terms. Emerging markets also fared well, despite China imposing large scale lockdowns on Shanghai and showing weakening manufacturing data, as investors appear to expect that Beijing will take measures to support the economy and financial markets. UK and US bond yields retreated, ending the week at 1.61% (down 8.4 bps) and 2.39% (down 9.8 bps) respectively. Oil fell by -13.9% as Joe Biden ordered the release of 180 million barrels of crude oil from the US Strategic Petroleum Reserve, ending the week at just under $100 per barrel.

CIO Analysis

A former (American) boss of mine once told me: “Manage, or you will be managed”.

A running theme in our publications has been the central bank’s “illusion of control”. The idea that interest rates are local, as opposed to supply-side inflation which is global. Raising the interest rate will have a local effect on demand, and growth. Certainly, when one raises the interest rate in the US, the world’s largest consumer market, it might have some measure of effect on global inflation. Conversely, however, raising it in the UK, population 66 million, will probably have less of a global footprint. So why raise at all? Will this fix supply chains, or stop the war on Ukraine and the concomitant Russian sanctions?

Central banks are playing from their standard playbook. As long as unemployment and growth are unaffected, they can afford to raise rates. However, eventually, growth and unemployment will be affected, in which case they know not to raise the cost of money anymore. What’s more, they can afford to do that, because of their much-vaunted independence.

But this time, in so many respects, is different. In the 1980’s the Fed was not fighting pure input inflation. It was fighting a change in the monetary system. And to make sure the economy would recover from the ensuing recession, it had been allowed to loosen regulation on banks and allow more lending. Banks are, after all, the transmission mechanism of monetary policy. This was making sure credit would flow. America’s global partners followed suit. Again rates were hiked in the early nineties, again banks were allowed to lend. By the next two rate hike cycles, at the turn of the century and 2006-7, banks were very much de-regulated. On the one hand, the four recessions which followed rate hike cycles were kept shallow. On the other, by 2008, the global banking system was nearly wiped out, because it failed to properly balance risks. Thus banks were not allowed unfettered lending any more.

Enter 2022 and the fastest inflation in fifty years. Central banks are hiking, but this time commercial banks don’t have the tools or the will to mitigate the damage. Remember just two years ago, at the height of the pandemic, how banks were reluctant to lend out money to businesses, even when 95% of the loans were covered by the state? It is safe to say that the transmission mechanism is problematic, at best.

Central bankers and governments are on their own. And the probability of recession, following rate hikes is rising fast.

How do we know this? The yield curve is inverting, which constitutes a powerful sign of recession. Of course the yield curve is not a magic crystal ball. Higher short term yields and lower long term yields suggest that borrowers attach a stronger probability that:

Central banks will hike short rates fast (short term yields rise)
Inflation at very high levels is not expected to persist (long term yields rising less quickly)

Yields are the consequence. Central bank policy and policy communication is the cause. What investors have to be prepared for, though, is much more significant. There’s a good probability that central banks will fail to keep prices stable, and cause stagnation or recession at the same time. This means that their ability to make decisions all by themselves could be significantly compromised. The leeway that is afforded to them by political authorities can be taken away. Even more so, if elected governments are looking for someone to pin the blame on. A Republican lawyer leading the Fed, a new BoE Governor, a politician at the head of the ECB make for attractive political targets.

This is the worst scenario for markets and portfolios. Asset prices over the last twelve years rose because of the central bank’s ability to make quick decisions without waiting for political approval. While US Congress was haggling over the half-trillion Troubled Asset Relief Programme (TARP) in 2008, the Fed was independently planning Quantitative Easing which ballooned to eight and then seventeen times that amount. And while European politicians were thinking about punishing weaker southern countries over the Euro crisis in 2011, Mario Draghi went off-script (and off-convention) to do the same, eventually rescuing the Eurozone. Central banks have caused much political consternation by printing record amounts of money and then keeping in a closed system to stabilise prices and stave off inflation, eventually, however, benefitting mainly the top income earners. But if they did not have that power, the story of asset prices and availability of cash at the ATM might have been very different in the past decade.

Make no mistake. Central banks need to change. They should take their standard playbook and hurl it into the sea. The need to be led by the brightest and most forward looking of economic minds, not the politically-adaptive and the consensus-forgers. They need to adapt their policies for a globalised market. For the meta-capitalism of a globalised world, away from the traditional nation-state. This would mean independence from their own authorities and close cooperation with each other. This mentality saved capitalism in 2008-9. But few are the heads of nation-states with the foresight to allow for the internationalisation of their monetary policy. It is more likely that, when the current form of independence fails, they will seek to take back control, and possibly risk the modern monetary system with them.

So what can asset allocators do? Think broadly and understand that such a sea-change won’t happen overnight. First, they need to watch for signals that the central banks are coming under fire for constrictive policies. Second, they need to monitor news about changes at the top of the hem. And third, they need to watch for possible legislation which would limit their independence. At every step, they need to prepare their clients’ portfolios for more volatility. Currently, what supports asset prices, the S&P 500 at 4500 points and the FTSE 100 at 7550 is the abundance of residual liquidity after a decade of unfettered money printing. More constricted central banks would be hard-pressed to maintain that liquidity, let alone expand it in the next crisis. Taking back central bank independence would effectively mean the end of the “Fed Put”, and would force investment managers to re-write their whole playbook.