“Just a little somethin’ to break the monotony...”
- Summertime, DJ Jazzy Jeff & The Fresh Prince
This week the market felt like a much-needed holiday was just around the corner. Over recent sessions, the rising concern over the global spread of the delta variant - notably present in the IMF global forecast revisions across Asia - and, even the Chinese regulatory clampdown have raised eyebrows and concern. But outside of localised stress (Nasdaq Golden Dragon China (Tech) index was at one point this week down over 50% from the February highs), not much has changed. Indeed, events such as these have brought with them audible prophecies of imminent doom for the US stock indices, only to find them at new record highs a few days later. The Old adage ‘Sell in May and go away’ may well have some historic seasonal backing, but the signal to noise ratio of the market's protestations suggests that perhaps we may well ‘...come back after Labor Day’ significantly higher still!
It is perhaps important to comment briefly on the recent Chinese equity market turmoil at this point. While sentiment towards China has been fractious this week, culminating in significant equity outflows, we are of the view that the recent regulatory intervention is consistent with Beijing’s long-term policy goals (socialism with Chinese characteristics, deleveraging and compositionally adjusting growth: quality over quantity). We do not think that China is trying to engineer an equity market collapse or hurt foreign investors at the same time as they are in the process of trying to enhance financial stability and upgrade the financial system. We do not see this as the straw that broke the Camel’s (dragon’s?) back.
From our perspective the glass remains half-full, from a global growth perspective. However, as we have consistently argued for many months now, quarters even, differentiation is key. Indeed, this was a factor clearly highlighted by the latest IMF World Economic Outlook (WEO) forecast revisions. The IMF kept the global growth forecast for 2021 unchanged but shifted the compositional growth components - upgrading DM (US and UK growth standout) and many emerging markets (EM), such as Brazil, Mexico, Russia and South Africa, while downgrading EM Asia (on Delta variant shutdown concerns).
This week has also seen the focus shift back to the US, with more audible progress on a bi-partisan infrastructure Bill, with passage possible as early as next week. Further, targeted fiscal stimulus in the US should be viewed in a positive light. Infrastructure investment in the US is profoundly lacking, and while the numbers are essentially modest (especially when split over the next decade), the impact is potentially significant.
The main event, however, was the Federal Open Markets Committee (FOMC).
Going into the FOMC meeting, there was no expectation of significant changes to the statement or policy. Ultimately, the central expectation for the formal announcement of tapering (the next step on the path to Federal Reserve (Fed) normalisation) is likely at the December meeting (with an implementation early in the new year).
Nothing that the Fed Chair said was inconsistent with market expectations going into the meeting as far as policy trajectory is concerned, but it is likely that the continued positive narrative surrounding the economy is more bullish than recent growth concerns suggested. The Fed Chair’s continued liberal use of ‘intensifiers’ in his commentary {Household spending rising at an especially rapid pace, housing sector is very strong, business investment is rising at a solid pace, demand for labor is very strong,...} add to the supportive narrative of progress in vaccinations and unprecedented fiscal support.
Essentially, the Chair has explicitly linked further labor market gains towards full employment - importantly physically attained, not just forecast, as is already the case - to the attainment of ‘Substantial Further Progress’ as defined by the Fed and thus the start of tapering. The Chair also acknowledged that there was a discussion about changes to the pace and composition of asset purchases - a further communication about the process itself.
My personal interpretation of the July FOMC is that the Fed are happy with the economic trajectory of the US and global economic backdrop. Furthermore, there was a modest downplaying of the likely economic impact of the delta variant. The caveat is that it is also likely that the Fed are very conscious that the first steps towards policy normalisation must be slow, predictable and well communicated. We are at the start of this gradual process. Jackson Hole is likely the next step (dependent on a strong employment report for July). On this basis, we see little reason why a stronger growth narrative and policy guidance consistent with central market expectations for policy action should be USD negative beyond a near term position adjustment (and perhaps some month-end flow distortion). At least in DM.
For EM, the case could be made that the Fed’s maintained confidence, but also maintained conservative approach to policy normalisation, leads to a relatively low and stable US yield curve and a more positive near-term backdrop for EMFX.
Markets continue to debate the proximity of ‘peak growth’ and the merits of USD weakness as a function of being past this peak. Our view remains that rather than focussing on the sequential or second derivative of growth as may be the case on a natural growth cycle, this ‘cycle’ is very different. The intentional shutdown and then graduated reopening of economies distorts the growth pattern in the near term and thus from our perspective the most important barometer is the equilibrium level of post Covid growth. In this regard we continue to see the US as widening its differential relative to the rest of DM.
Furthermore, if we are right in the view that inflation proves transitory, then we could well be in a position at the start of 2022 where the US has begun its process of monetary normalisation by tapering asset purchases and, at the same time, the decline in headline inflation is putting pressure on the European Central Bank (ECB) to respond to the demand-led shortfall in inflation at the forecast horizon, by adding further monetary accommodation.
With the Fed and the ECB meetings out of the way and what feels like a period where many will take a well-deserved break, we could be truly in for some summer markets over coming weeks. However, while it may well be “time to sit back and unwind” we remain cautious of old adages or consensus views!
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