Feeling the Pinch of Tighter Monetary Policy
Author: Kevin McCreadie
January 26, 2022
Does inflation need to be reined in by central banks? Or will it wane on its own as government stimulus begins to fade and economic conditions finally normalize following the latest wave of the pandemic? Kevin McCreadie, AGF’s CEO and Chief Investment Officer, explains how the current response to this debate has investors on edge and why the stage is set for even greater market volatility ahead.
As you forecasted in AGF’s Outlook, higher inflation and the prospect of higher interest rates have led to increased market volatility to start the new year. Is there anything that surprises you about the recent pullback in stock markets and subsequent rise in bond yields?
Markets are behaving much as we thought they would and they’re behaving this way for most of the same reasons we thought, too. That said, the past few weeks have not been entirely predictable.
For one thing, the U.S. Federal Reserve has grown much more hawkish about tightening policy in the face of higher inflation than it was a few months ago. Remember, the Fed only began tapering its quantitative easing (QE) program in November and it was only mid-December when it re-jigged its interest rate “dot plot” to now anticipate three rate increases in 2022 and three more in 2023. Before that, the dot plot showed most Fed officials expected only one rate hike this year.
Then, earlier this month, the minutes of the Fed’s December meeting were published, detailing a plan for the central bank to reduce its nearly US$9-trillion balance sheet by starting to let maturing bonds “roll-off” sometime after it begins raising interest rates. So, not only are most investors having to contemplate the certitude of higher interest rates this year, but they are also now facing the prospect of quantitative tightening (QT) removing liquidity from the market much sooner than most of them had previously considered.
All of that has led to the tremendous pullback we’ve seen in the shares of long-duration growth companies whose earnings – or even ability to generate a profit – are more susceptible to higher interest rates than the value-oriented cyclical names that have outperformed them of late. And of course, further fuelling the fire of this rotation is the fact that valuations in many growth stocks had become extremely expensive relative to their value counterparts in recent years and may have been due for a correction in any event.
In other words, the market is re-calibrating in anticipation of a much tighter monetary environment than it has grown used to over the past two years. Clearly, this is a nerve-wracking process, but if the Fed and other central banks are measured in their approach, it’s one that should give way to new opportunities and better returns for stocks than has been the case so far this year.
What if the Fed isn’t measured and its plan to tighten policy ends up being too aggressive?
There are good reasons why the Fed and other central banks including the Bank of Canada (BoC) want to be less accommodative. The most important, of course, is to curb inflation, which is rising at its fastest rate in decades and is well above central bank targets in both the U.S. and Canada. Moreover, tightening now, when the economy is growing at a healthy pace, means the Fed and BoC will be in better position to loosen policy the next time economic growth falters in a sustained and serious way.
The risk to investors, therefore, isn’t necessarily the idea of tightening as much as it is the execution of it. And, in this case, the biggest concern lies in central banks making a policy mistake that inadvertently causes an economic slowdown because they moved too aggressively. This concern is particularly acute for those who believe inflation will abate in the coming months regardless of what the Fed and other central banks have planned. But even those who believe multiple rate hikes are necessary to stem inflation’s tide need to be careful. The risks of tightening monetary policy too much or too fast going forward are great and could create even more volatility than we are experiencing today.
What about the market impact of Omicron, the latest variant of concern in the COVID-19 pandemic?
It seemed like the worst of the pandemic was over in the fall and then Omicron hit and, just like that, we were back on high alert, investors included. Remember, equity markets had one of their worst one-day selloffs when news of the Omicron variant first made headlines. Yet, since then, Omicron has become a secondary headline for markets that has not played much of a factor in the recent performance of stocks and bonds. And that isn’t likely to change now that case counts and hospitalizations are on the verge of peaking in several countries.
That doesn’t mean Omicron is no longer a potential risk. Economic activity has certainly waned over the past two months because of it and the variant may also prolong the ongoing disruptions to global supply chains – especially now that it’s been detected in China, one of the world’s busiest manufacturing hubs. Still, if there’s one thing that investors are worried about these days, it’s not Omicron, but the tighter monetary conditions now in store for them.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor to AGF Perspectives.
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The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
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