Investor sentiment has also been helped by global developments; China laid out plans to support the struggling property sector and has outlined a recalibration of its economically harmful zero-COVID policy. Meanwhile, data continues to show that a mild Northern Hemisphere winter so far has made it easier for European nations to build up gas in storage—reducing the threat from reduced supplies from Russia.
But we believe it is too soon to assume a shift in Fed policy. Fed Governor Christopher Waller said at the start of the week that the central bank still had “a ways to go” before ending rate hikes. That chimed with remarks last week from San Francisco President Mary Daly, who said the release was “far from a victory.”
In addition, we are seeing signs of financial fragility as the knock-on effects are felt from the end to more than a decade of ultra-easy monetary policy.
The bankruptcy of crypto exchange FTX—while driven by company-specific factors—underlines the threat to speculative assets as global liquidity ebbs. The news that FTX had failed left other digital exchanges seeking to calm anxiety among clients regarding the safety of their funds. FTX, which was valued earlier this year at USD 32 billion, had just USD 1 billion of easily sellable assets and USD 9 billion of liabilities, according to a report by the Financial Times. The value of Bitcoin fell close to 23% last week and is now down 64% year to date.
Recent developments support our longstanding view that cryptos are a highly risky investment proposition, given the potential asset runs along with limited transparency or regulatory oversight. The reduction in central bank liquidity has added to the vulnerability of this market.
Disruption in the UK gilts market in 2022 starkly illustrated the challenges facing governments who try to increase borrowing at the same time as central banks sell government bonds to try and reduce inflation. While there were idiosyncratic aspects of events in the UK, the set of challenges facing the UK are not unique, and a risk for next year is that the UK might be a forerunner of financial instability in other markets. In the Eurozone, we are monitoring the risk that the unwinding of quantitative easing could prompt stress in bond markets. The ECB’s Transmission Protection Instrument is designed to mitigate these challenges, but it remains unclear how it would work in practice, and it is unlikely to be deployed proactively, notably in markets that would have to experience disruption first.
In the US, as the Fed conducts quantitative tightening, we are monitoring for the risk of a funding squeeze. This would be similar to 2019, when the Fed’s balance sheet run-down caused an undue tightening in dollar funding conditions. A key challenge is that the process of quantitative tightening reduces banks’ excess reserves faster than lending made against those reserves is unwound. This effectively increases leverage, and the system’s vulnerability to shocks.
So, as the effects of tighter policy intensify, we continue to favor a defensive investment stance. In equities, we are least preferred on the technology sector, which is most susceptible to higher rates. Instead, we favor sectors that are less vulnerable to a slowing economy and higher rates—including consumer staples and healthcare. Value looks set to continue to outperform growth, in our view, given that inflation—though past its peak—will likely remain elevated for some time to come. In fixed income, we prefer high grade and investment grade bonds, which offer greater protection against weaker growth.
Main contributors - Mark Haefele, Vincent Heaney, Christopher Swann, Alison Parums, Jon Gordon
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