NN IP: Too early for a dovish pivot

NN IP: Too early for a dovish pivot

Monetary policy
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Despite hawkish comments from both the Fed and the ECB, investors are still hoping for a dovish pivot. While central banks might reduce the pace at which they are tightening, they are likely to keep rates at or close to terminal rates for longer than initially expected. Meanwhile, economic growth is slowing down further, particularly in Europe.

Recent rumours that the Chinese authorities are preparing an end to their zero-Covid policies have created renewed optimism about a rebound in Chinese growth. However, for the time being, with the number of Covid cases in China accelerating again, new mobility restrictions are being put in place. Against this backdrop we made no changes to our multi-asset model portfolio over the past week, which means that we remain underweight in equities for now.

Economies continue to struggle

With inflation still high and central banks sending further hawkish signals, economic growth is struggling around the world. This has been reflected in deteriorating PMIs in the US, Europe and Asia. In the US, consumer spending has been more resilient than in other regions, which can be explained to a large extent by the labour market remaining tight. In the Eurozone, household spending is still the weakest link as high gas and electricity prices are hitting purchasing power and consumer sentiment. The Eurozone economy is likely to contract both this quarter and next. In Asia, growth headwinds are mostly in the form of weakening demand for electronics, which has resulted in lower exports, and weak Chinese demand due to the country’s zero-Covid policies and slumping housing market. We have not changed our cautious short-term, more optimistic medium-term and below-consensus longer-term expectations for the Chinese economy.

Central banks remain hawkish

So far, slowing economic growth has not made central banks less hawkish. The disinflationary impact of lower growth remains uncertain and, for now, both the Fed and the ECB are continuing to focus on minimising the risk of inflation expectations breaking out on the upside. While central banks are aware of the risks to growth and the financial system resulting from the sharp tightening of financial conditions, they remain focused on inflation, which is still well above their target levels. This Thursday, US CPI figures for October will be published. Consensus expectations are for a modest decline in core inflation from 0.6% to 0.5% month-on-month, which corresponds with 6.2% annualized inflation. A meaningfully lower reading will be necessary for the Fed to become less hawkish. In the last FOMC meeting, Fed Chair Jerome Powell made it clear that it was “premature” to start thinking about pausing monetary tightening and that the Fed still has some way to go before reaching the terminal rate. We expect the Fed’s terminal rate will be at least 5%.

The sentiment that the Fed was getting closer to the end of its tightening cycle had pushed yields down somewhat in recent weeks, but these hawkish comments have led to renewed upwards pressure on US Treasury yields. The ECB’s messaging has also been interpreted in different ways recently. While remaining very much focused on the fight against inflation, the bank has increasingly been emphasizing downside risks to growth. Like other central banks, the ECB has reached the point at which it needs to assess the impact of the monetary policy tightening that it has already implemented.

Potential for credit spreads to tighten

We remain neutral in rates. With inflation still high in both the US and Europe, we see limited room for interest rates to fall in the short term. We might get a bit more clarity on how central banks perceive the disinflationary impact of lower growth or even a recession in their December meetings. This could lead to a reduction in rate hike expectations for next year. We would expect rates volatility to fall in a scenario in which market participants anticipate a peak in policy rates. This would also make credit spreads look more attractive from a risk/reward perspective. With interest rate volatility having been a key driver of wider credit spreads, we expect investors to increasingly try to benefit from low valuations. Our assessment that the macroeconomic backdrop remains unfavourable for credit makes a complete retracement in spreads back to their levels at the beginning of the year unlikely. But the prospect of lower rates volatility should make carry look more attractive and help push spreads down over the medium term.

Still underweight in equities

Global equities have been driven by opposing forces over the past week. On the one hand, the FOMC press conference was hawkish and further dented hopes of a quick policy pivot. The rate-sensitive technology sector, which had already suffered from weak results in previous weeks, took the biggest hit. On the other hand, the rumours in China about an end to zero-Covid policies caused some optimism about growth that we have not seen for a while. Commodity-sensitive and the energy sectors benefitted most. This divergence in sector returns explains most of the US’s recent underperformance of Europe.

The Q3 earnings season is almost over. 90% of the S&P 500 has reported, of which 70% beat expectations. The average beat of 4% is modest if we take into account the sharp downwards revisions that had been communicated before Q3 reports. In absolute terms, quarterly earnings rose by 4%, while revenues were up 12%. We expect margins to remain under pressure as companies will find it increasingly difficult to pass on higher costs to their customers, particularly in a period of slowing economic growth. We expect US earnings to remain flat in 2023 and European earnings to fall by 10%.

For now, we maintain our long-held moderate underweight in equities as the outlooks for economic and earnings growth remain bleak. What’s more, with inflation remaining high, we see limited scope for central banks to become less hawkish. Meanwhile, sentiment indicators, such as the bull/bear ratio, the put/call ratio and the VIX, which were in contrarian buy territory for most of the year, have turned neutral recently. Positioning in S&P 500 futures remains low.