Global Markets View - Dec 16
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* In its policy meeting yesterday, the US Fed was not more hawkish than expected which was a relief for markets. S&P500 ended up 1.6% while Nasdaq was up 2.2%. US 10-yr ended flat at 1.46% and Dollar index at 96.3. Gold ended up marginally at $1,778.
* As expected, Fed:
* Highlighted inflation as the #1 threat currently. Core PCE inflation, the Fed’s favoured measure, was revised upwards by 70 bps to 4.4% in 2021 and is expected to come down to ~2% only by 2024.
* Doubled tapering to $30 bn per month, effectively ending QE by Mar’22. However, Fed has not revealed its balance sheet shrinking plans.
* Signalled 3 rate hikes in 2022, along with further 3 hikes in 2023 and 2 in 2024.
* Markets are now attributing a 100% chance of the first rate in June’22, and a ~50% chance of it being pulled forward to Mar’22 if inflation and inflation expectations move meaningfully higher.
* Today’s announcement still represents a shallow rise in rates as the real fed fund rate will continue to remain negative at -0.7% (fed rate minus core PCE inflation projection) even by the end of 2023. And it does not turn positive by the end of 2024. So, this is still supportive for equity markets.
* After 5.5% growth in 2021, the real GDP growth is projected to decelerate to 4% next year, which will still be very strong compared to the potential long term at 1.8%. The potential impact of the Omicron wave has also been downplayed as the Fed thinks that the economy is fairly strong to withstand it, as is the case with the current delta variant that has been currently spreading in the US.
* The US economy is rapidly moving towards full employment. Fed lowered its projection of unemployment rate for 2022 to 3.5% from 3.8%. Fed now thinks that the decline in labor participation rate (LPR at 61.8%) is unlikely to regain the pre-COVID level of 63.4% any time soon, thus implying an enduring backward shift in labor supply, sustaining into high wage and price inflation.
* The shallow lift-off trajectory will ensure that the financial markets do not immediately react adversely to the normalization. But what is imminent now is that Fed’s assurance of persistent accommodative support for the financial market will get diluted. This would imply higher market volatility going forward. Also, a quicker taper and rate lift-off can induce other central banks like ECB and BoE who are also facing high inflation to start their normalization process.
* While the US economy is running quite strong, the global economic landscape is not as strong, especially in Emerging Markets (slowing China, slower recovery from Covid, sluggish credit cycles, etc.). Hence, while the Fed stance may be suitable for the US economy, it may prove challenging for the global economy. Flat US yield curve and a strengthening dollar point to this.
* India will also see financial conditions becoming tighter. Inflation is also seen rising in India due to recovery in consumption demand, and the backlog of higher cost inflation, thereby leading to initiation of rate hikes by the RBI.
* Stronger dollar on the back of Fed’s normalization will lead to continued weakening INR/USD. Export oriented sectors such as IT and Pharma would benefit.
Source: ABSLAMC Research