Invesco’s Kristina Hooper – The Monster Under The Bed

Market participants are letting their imaginations run wild about Fed tightening this year. But often, reality is better than what we imagine, says Invesco’s Global Market Strategist Kristina Hooper.

Key takeaways

• Markets are worried about rate hikes:

There’s so much anxiety about what the Federal Reserve will do this year, given the high level of inflation.

• But the Fed has multiple tools at its disposal:

From my perspective, markets are overestimating the number of rate hikes that will occur this year.

• We’re on the road to normal:

We’re seeing multiple signs of normalization that suggest we are getting closer to pre-pandemic conditions. There are just a lot of bumps between here and there.

I remember when my children were young, they were all so afraid of what was under their bed at night. They couldn’t help but let their imaginations run wild, envisioning the worst possible things residing under their bed after dusk — horned and fanged monsters with an appetite for little children, and the occasional garden-variety mass murderer. In the morning, when they got the courage to look under the bed, they would always realize that their fears were worse than the reality of a few dirty socks. And so it is with investors imagining the worst possible scenarios for Federal Reserve (Fed) tightening this year. I suspect reality will be considerably better than their worst fears.

It’s been breathtaking to watch the dramatic change in expectations surrounding the Fed this year. Estimates for rate hikes are all over the place, but they’ve been trending a lot higher in the past couple of weeks — and we’ve seen stocks and other risk assets fall in response. There are whispers that the Fed will end asset purchases at this week’s meeting; others think the Fed could start to raise rates at this week’s meeting. And some are anticipating as many as eight rate hikes this year — that may be worse than the giant eight-legged hairy spider under the bed that wanted to kidnap my daughter and bring her back to its human-sized web.

Let’s face it — there’s so much anxiety about whether the Fed will be forced into getting aggressive because of the level of inflation, and in doing so make a policy error. But from my perspective, markets are overestimating just how much the Fed will tighten this year.

Signs of ‘normal’ ahead

The Fed has three tools it plans to utilize this year to help combat inflation — tapering its asset purchases, raising rates, and reducing the size of its balance sheet. Given the range of tools at its disposal, I feel strongly that there is less pressure on the Fed to rely on its traditional tool — hiking rates — in a dramatic way. That doesn’t mean it won’t try to act quickly; however, acting early doesn’t necessarily mean acting often. In other words, inflationary pressures may impact timing, but as we have learned from past rate hike cycles, it’s not when the Fed begins but where it ends that will have a bigger impact on assets.

It’s understandably unnerving for investors at the start of the tightening season to ponder what could happen this year. I think it’s important to step back and see the bigger picture. In my view, much of what we have seen in recent weeks, some of which is causing unease for investors, signifies that we are on the path to “normal” for the global economy and markets:

• We’ve seen a real and significant global stock market sell-off. For the last 22 months, we’ve seen just a few stock sell-offs, mostly shallow, followed by rapid recoveries as market participants quickly piled back into stocks. The behavior we’ve seen over the last few weeks is reminiscent of a more normal market environment, punctuated by a very significant sell-off without an immediate recovery.
• “Stay-at-home” stocks have been tanking. Yes, Omicron is still raging in parts of the world, but in other parts it has already peaked. Stocks are clearly discounting a return to something more like a pre-pandemic world with people back to normal routines of gym visits and more entertainment outside the home.
• Supply and demand conditions are normalizing. We’re starting to see pent-up demand being burned off and supply improving. For example, the Empire Manufacturing Survey for January revealed a drop in new orders, a drop in unfilled orders and a drop in delivery times.¹ In addition, inventories rose. It was recently reported that both China and Vietnam are asking workers not to travel for the Lunar New Year in order to help reduce the spread of COVID-19 and therefore try to prevent labor shortages that can exacerbate supply chain issues.² This should help ease inflationary pressures.
• We expect economic growth to improve in China. Fiscal and monetary stimulus should help boost Chinese growth, moving closer to trend, in our view. Corporate earnings appear on track for a good year: Consensus expectations are calling for earnings per share growth of 13% for China for 2022.³

So let’s not fear higher rates — we’re seeing multiple signs of normalization that suggest we are getting closer to pre-pandemic conditions.