As expected, the Fed yesterday raised its policy rate by 0.25% to 5%. Meanwhile, Treasury Secretary Janet Yellen said that a deposit guarantee scheme covering all deposits is not under consideration, a comment that sent share prices down.
In this post, we briefly discuss yesterday's Fed rate decision and the inflation picture. Then let's see how Europe seems to be dodging the energy crisis. No wonder that in our part of the world equities have been overperforming.
Fed raised the policy rate
Yesterday's Fed rate meeting could mark the peak of the current rate hike cycle. If the banking crisis had not occurred, the policy rate might have been raised by up to 50 basis points. Fed members see perhaps one more notch of rate hikes to come, meaning that the peaks are within reach at current levels.
On the other hand, members don’t expect a rapid fall in policy rates. The events of recent weeks will take care of some of the monetary tightening. As I highlighted in the last post, monetary conditions have tightened dramatically in the market. At least officially, the Fed is keeping the banking system stable, and the main antagonist is still inflation. Of course, they can't say otherwise in their official capacity, so some of Powell's mumbo jumbo should be taken with a grain of salt. From the Fed's perspective, the economic outlook has also darkened, although the labor market remains too strong and inflationary.
Contrary to Fed members' expectations, the market expects the policy rate to start falling already by the end of the summer.
The current level of the policy rate is the highest since the hot summer of 2006. The policy rate has risen historically sharply, but I took data back to the 1970s for this graph so you can see how the policy rate bounced even more wildly in those inflationary times.
In the market, views on the future direction of inflation vary wildly. Some argue that inflation will fade into the background as bank lending stalls due to the banking crisis. But so far, there is still too much money floating around in the system. During the pandemic, the US M2 money aggregate (includes cash, deposits and money market funds) jumped by up to 30% and by $6,000 billion in absolute terms. Now, for the first time in the history of the statistics, M2 money is falling on an annual basis. This graph shows the annual change in both M2 money and inflation. Assuming that inflation is largely a monetary phenomenon, a fall in the money supply should at some point be expected to weigh down inflation. If the banking crisis were to escalate, this process would be all the faster.
On the other hand, by many measures, inflation is still persistent. Just as a reminder, core inflation excluding statistically fiddling shelter costs is over 5% per year and 3-month annualized inflation actually accelerated in February. Similarly, wages are growing by more than 5% a year.
Equities have already clearly adjusted to the current inflationary regime. Last year's beating was due to inflation accelerating unexpectedly. Now companies have had time to adjust and raise their prices. In many sectors, cost pressures are already easing as raw materials become cheaper. The 5-year inflation outlook for the US is so far stuck at over 2%.
For inflation to devastate equities further it would have to accelerate sharply again. This is possible if the central bank takes its foot off the brake too early. In this sense, the bigger concern for the investor is whether something in the system will break down again. The few bank casualties from recent weeks still stink.
Even the failure of banks, if controlled, won’t necessarily derail the market. As a curiosity, here are FRED's statistics on the failure of financial institutions over the last 50 years. In the 1980s in particular, banks were failing at the rate of hundreds a year, even as stock markets were in the early stages of the biggest bull market in history. As I understand it, the collapses at the time were precisely related to the weak interest rate risk management of banks as the Fed sharply raised interest rates and kept them high. If bank failures remain under control, the situation doesn’t have to escalate into another financial crisis.
Europe is dodging the energy crisis
The winter depletion of European natural gas stocks seems to have come to a halt, even though they are still more than 50% full. I marked the corresponding time last winter on this graph. Usually, the natural gas stocks are already empty at this stage. I am not an expert on the European energy market, but with ample reserves and growing LNG capacity, Europe looks set to dodge the energy crisis bullet next winter as well, removing one fundamental worry from investors' risk map.
This graph shows European natural gas consumption and the share of LNG in consumption. Cutting off Russia's gas taps has been combated by curbing domestic consumption and shipping gas around the world to Europe.
In fact, one energy economics institute even argues that if European gas consumption continues to fall with the energy transition and the planned LNG capacity is completed at the same time, we will have numerous unnecessary LNG terminals lining our shores by the end of the decade.
Necessity is the mother of invention. In this way, the crisis of scarcity is again becoming more of a crisis of abundance. For European equities, the resolution of the energy crisis is of course a good thing, as doubts about the continent's competitiveness and one of the drivers of inflation are removed from the scene.
This graph shows the EPS forecast for STOXX 600 index 12 months forward. Last fall, I repeatedly raised the skeptical issue of how results could supposedly withstand the pressure of the energy crisis. Now it seems that this skepticism was misplaced and if you want to make up worries about the results you have to look at the possible recession and inflation.
But so far, the recession seems to be receding. This graph shows the consensus GDP growth forecast for the eurozone for the current year. Forecasts are forecasts, but at least so far the expectation of a recession has changed to 0.5% economic growth.
The relative strength of Europe is also reflected in the better performance of European shares during the past 12 months. The S&P 500 has lost 12% of its value over the year, while euro shares have managed to hold their ground.
The focus of many investors is on the US, where stocks have outperformed since the financial crisis, but no continent's winning streak will last forever. European stocks are cheaper, while many of our companies are benefiting from the Asian boom or the green shift. There are also many banks in Europe that are benefiting from the high interest rate environment so far.
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