The Fed’s hawkish pivot prompts mixed responses

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2022 Outlook:
  • U.S. economy: Slower growth and inflation compared to 2021, but still pretty fast.
  • Global economy: Showing signs of heating up thanks to accelerating vaccination rates.
  • Policy watch: No more stimulus, but the Fed isn’t likely to raise rates too quickly.
  • Fixed income: Expect further challenges for rate-sensitive assets; consider assuming more credit risk.
  • Equities: Our cyclical tilt includes U.S. small caps and non-U.S. developed market shares.
  • Asset allocation: Although valuations appear relatively full across many segments, we’re leaning toward risk-on positioning.

Quote of the week:

“We hate the hawk because he ever lives in battle.” – Ovid

Central bank watchers kept their popcorn ready

Last week, three of the world’s most important central banks met, delivering a variety of monetary policy changes. But one thing’s for certain: the days of unprecedented easing and seemingly limitless liquidity are winding down.
Wednesday brought the main event: The Federal Reserve’s finale for 2021. Due to hotter inflation and a tightening labor market, the Fed announced that it will double the amount by which it tapers its quantitative easing (QE) asset purchases, from $15 billion/month to $30 billion/month, beginning in January. This faster pace means QE will end in March 2022.
In addition, the Fed pledged to keep the federal funds rate at its current 0%-0.25% target range until the labor market reaches maximum employment. (This occurs when virtually all who are willing and able to work have the opportunity to do so.) At the same time, however, the closely watched “dot plots” showed that most Fed members foresee three rate hikes in 2022 — up from less than one in their September projections. The Fed rarely changes course so rapidly, but the U.S. economy has strengthened notably since then. For example:
  • The four-week moving average of weekly jobless claims plunged to levels last seen in 1968.3
  • Housing starts and building permits (a leading indicator of future homebuilding) have surged.4
  • Service-sector activity, which makes up about 75% of overall GDP, hit a fresh all-time high in November, according to the Institute for Supply Management’s purchasing managers’ index.5
Against that solid backdrop, the Fed upgraded its GDP outlook for 2022, from 3.8% to 4.0%, while dropping its forecast for unemployment, from 3.8% to 3.5%. In terms of inflation, the Fed believes a 2.7% rate in the core Personal Consumption Expenditures (PCE) Price Index — its preferred inflation barometer — is in store by the end of next year.6 And if the Fed’s projection proves correct, consumers should perceive a major downshift in the rate of price increases, even if the mix of inflation switches to categories like rents and other non-goods segments, some of which were not subject to the supply-chain bottlenecks that have fueled inflation this year.
The S&P 500 Index rallied in the immediate wake of last week’s Fed meeting, cheering both the resolve of Chair Jerome Powell and his colleagues to rein in inflation and their bullish economic viewpoint. In contrast, bond markets were sedate, with the 10-year U.S. Treasury yield little changed amid a prevailing longer-term view of slower growth and cooler inflation.
Overall, investors — and even the Fed — may be anticipating too many rate hikes next year. Indeed, we think fewer than three will be needed based on our belief that inflation should decelerate sharply as supply-chain woes ease and more workers enter (or re-enter) the labor force.
Even before markets had time to fully absorb the Fed’s decisions, two other central banks made headlines:
  • The Bank of England (BOE) became the first G7 central bank to raise interest rates this cycle. (The G7 consists of the U.K., the U.S., Canada, France, Germany, Italy and Japan.) Most economists had expected the BOE to hold rates steady (at 0.1%) in light of the spread of the Omicron variant and concerns about its potential economic impact. But with U.K. inflation hitting 5.1% in November — its highest level since September 2011 — the BOE felt compelled to act, tightening by 15 basis points, to 0.25%.7 In contrast to the Fed, the BOE decided to leave its monthly QE purchases intact. In the first half of next year, we’re looking for at least one more BOE hike, and for its tapering to begin.

  • Despite an increase in inflation from 4.1% in October to 4.9% in November, the European Central Bank (ECB) held the line on rates at -0.5%.8 Negative rates force banks and other institutions to pay interest to a central bank for parking their excess cash (i.e., beyond what regulators require they must keep on hand). This policy is designed to provide an incentive to banks to lend money to consumers and businesses.

    The ECB also announced that in the first quarter of the new year, it expects to conduct asset purchases under its QE Pandemic Emergency Purchase Program (PEPP) at a “lower pace” than in the current quarter, and to wind down that program altogether by the end of the first quarter of 2022. (The PEPP was launched in 2020 to counter the financial devastation of the pandemic.) But to cushion the impact of fewer PEPP purchases, the ECB will continue its Asset Purchase Program (APP), which it began in 2014, until at least October 2022 to “reinforce the accommodative impact of its policy rates.” APP bond-buying is expected to end shortly before the ECB begins to raise rates.
From our perspective, it's highly encouraging that markets are digesting all of this news as well as they are. For now, despite ongoing COVID-19 risks, investors seem less concerned about the slower-growth message in our 2022 Outlook and more focused on our “…but still pretty fast” qualifier.

About our “risk-on” equity market call for 2022

But first, a brief definition. Markets are considered “risk on” when investors are optimistic about economic growth and invest in riskier assets offering higher return potential. And as we explained in the recently published Global Investment Committee’s 2022 Outlook,  we’re currently in risk-on mode, favoring (1) U.S. small caps (as measured by the S&P 600 Index) and (2) developed non-U.S. markets, especially in Europe (per the MSCI EAFE Index, a gauge of equity performance across 23 developed markets in Europe, Australasia and the Far East).
What could propel both of these asset classes ahead of the S&P 500 Index, often the top performer among major global equity benchmarks, in 2022? Their larger weight in the financials sector, specifically commercial banks. While much of 2021 provided a mostly positive backdrop for U.S. financials thanks to strong economic growth, higher interest rates and (still) loose financial conditions, long-term Treasury yields have been restrained more recently by fears over COVID-19 variants. (These yields help determine how much banks charge to lend money.) Meanwhile, the economic recovery in Europe has been rockier than in the U.S. because many countries there tend to enact restrictive mitigation strategies to prevent the spread of COVID-19.
Healthy GDP expansion in the U.S. and Europe is still our base case for next year, along with lower inflation and a pickup in long-term interest rates. COVID-19 remains the most serious near-term risk to our constructive view on cyclical (economically sensitive) stocks, but we believe even a bad Omicron wave would likely knock the economy off course for only a quarter. Meanwhile, small-cap stocks are significantly less expensive than large caps. Indeed, the valuation gap between U.S. large- and small-cap stocks is the largest it’s been in 20 years, creating attractive buying opportunities.9 Outside the U.S., the MSCI EAFE Index offers one of its highest risk premiums vs. U.S. shares since 2008 — another factor favoring international stocks.10 (The higher the risk premium, the more investors are compensated for assuming greater risk.)
Earnings growth projections for 2022 are not particularly high for small caps or non-U.S. developed-market stocks, meaning there’s potential for upward revisions – another positive. That said, we don’t expect anything like the surge in earnings growth that we saw in 2021. Such a rebound from pandemics happens only once.
TO OUR READERS: This will be our last edition for 2021. We look forward to publishing again on January 10, 2022.
  1. Bloomberg
  2. Federal Reserve via Haver
  3. Federal Reserve Bank of St. Louis
  4. Census Bureau via Haver
  5. ISM
  6. Federal Reserve Bank
  7. Office of National Statistics via Trading Economics
  8. Eurostat
  9. Bloomberg
  10. Bloomberg
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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