The Powell Pivot

Better luck next time, Build Back Better?

Senator Joe Manchin told a media outlet over the weekend that he is a “no” on the $1.75 trillion bill. It is not clear if certain components of the bill could still be passed or if negotiations may be reignited in early 2022, but his comments appear to greatly reduce the odds of the key legislation passing in its current form. Betting markets are now predicting just a 1% chance that the final price tag will be $1.75 billion or higher.

U.S. retail sales increased by 0.3% in November.

However, when the jump in prices is accounted for, real retail sales fell by 1.2%. Although the headline came in below expectations, nominal retail sales are still up 16.5% year-on-year. It’s also worth noting that these data do not reflect any potential impact from the Omicron variant. As of right now, economic activity still appears to be robust with the Atlanta Fed’s GDPnow tracker pointing towards 7.1% real gross domestic product (GDP) growth in the fourth quarter of 2021. However, it would not be surprising to see growth cool some in the first quarter of 2022 as the Omicron variant weighs on activity.

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Federal Reserve Chair Jerome Powell delivered on his promise to speed up the pace of bond purchase tapering by doubling the rate from $15 billion a month to $30 billion a month. Assuming there are no further changes, the Fed’s latest round of quantitative easing (QE) will come to an end by March 2022. The Fed also stated that it envisions hiking interest rates three times next year. While the first rate hike could in theory come as soon as March, the most likely timing still appears to be a June rate hike, a September rate hike, and a December rate hike. That may sound alarming, but one rate hike per quarter is a modest pace of tightening. The Fed also envisions three additional rate hikes in 2023 and 2024.

Interestingly, financial markets are less convinced that the Fed will be able to achieve this number of rate hikes over the next few years with Eurodollar future contracts pricing in 1.50% for short-term rates over the same period – implying that the market envisions a shallower cycle of Fed rate increases. The pace of the rate hikes is very important with equities often performing better during slow tightening cycles than in fast tightening cycles (see figure 1). During the last 10 tightening cycles, the S&P 500 returned an average of 9.2% in the year that followed the first rate hike of “slow” tightening cycles (less than six rate hikes in the first year) and returned just 0.2% during “fast” tightening cycles (more than six rate hikes in the first year). We think a slow tightening cycle is much more likely to occur.

While the Fed can do little about the supply bottlenecks that are contributing to higher inflation, by preparing for rate hikes now the Fed may reduce the risk of a policy mistake down the road. With monetary policy often leading the real economy by about nine months, signaling future actions now may help lessen the need to act aggressively later if inflation proves persistent. The last thing that Fed wants is to tighten monetary policy too quickly and accidently kill of the economic expansion.

Another interesting aspect of the Fed meeting was the Summary of Economic Projections, which painted a pleasant economic outlook for 2022. The Fed envisions a 4.0% real gross domestic product (GDP) growth rate, a 3.5% unemployment rate, and a personal consumption expenditure (PCE) inflation rate of 2.6% in 2022 (see figure 2). Above-trend growth, extremely low unemployment, and elevated, but reasonable inflation would likely be a supportive backdrop for equities.

U.S. stocks initially rallied after the Fed’s announcement as apprehension over the potential for more hawkish steps eased, but U.S. equities still closed the week lower with investors rotating out of technology stocks and into consumer staples. Typically, growth stocks are more sensitive to the prospect of higher interest rates because a higher proportion of their cash flows will be received in the more distant future.

However, thus far, long-duration rates have been falling with the 10-year Treasury yield falling 26 basis points since November 23rd. We think that long-duration yields are reflecting a couple of dynamics: 1) lower yields overseas have increased the appeal of U.S. Treasuries and 2) long-run growth and inflation expectations have cooled recently with commodity prices also coming down some (see figures 3 and 4).

This line chart shows the 10-Year U.S. Breakeven Rate in percent from January 2020 to 2021 Year-to-Date.

This line chart shows the S&P GSCI Commodity Spot Index from January 2020 to 2021 Year-to-Date.

We believe Citi’s Global Investment Committee is well positioned for this type of environment with half of its global equity overweight already centered in global healthcare stocks, which have climbed 4.3% since the start of December. Since the start of December, the S&P 500 Consumer Staples sector is up 6.6% as markets perhaps sense the end of the input price surge and perhaps the end of inflation more broadly. The sector is also ripe for a period of “catch up” having returned just 12% year-to-date while the broader S&P 500 has returned 23% year-to-date (see figure 5).

This line chart shows the S&P 500, Global Healthcare, S&P 500 Consumer Staples for 2021 Year-to-Date.

A Holiday-Shortened Week and A Hopeful Omicron Message

Lastly, financial markets could see outsized moves based on Omicron developments amid weakened market liquidity as many traders take the last few weeks of the year off. If there is a potential silver lining to Omicron, it could be that its higher rate of transmission may make its impact more short-lived. If we look at South Africa, where the variant is thought to have originated, Health Minister Joe Phaala recently reported that they are experiencing a much lower rate of hospitalizations and there may be signs that the wave of infections is already peaking. Only 1.7% of identified cases were admitted to the hospital in the second week of infections in the fourth wave, whereas 19% were admitted during the Delta-wave. Omicron has certainly come at a bad time of the year, but we hope that everyone is still able to enjoy some needed time off in the days ahead and that everyone has a safe and wonderful holiday season. We sincerely wish you and your family the best year ahead.

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