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Why markets have fallen

Over the last five days there has been a sharp fall of 5% in the European and Japanese equity indices, with a lesser fall in the US and UK. Two of our bear-case scenarios have come to worry markets.

| 4 min read

The discovery of the Omicron variant of the virus has led to a sell-off in shares in social-contact businesses as people consider what if the virus defeated current vaccines and led to widespread lockdowns again.

The words of the Fed Chairman last night reinforced concerns that the Fed has underestimated the inflation threat and will now need to take faster action to withdraw stimulus and raise rates. There is scope for a policy error of getting too tough to follow a policy that has been too easy.

Our base case assumes a moderate pace of monetary tightening, well flagged by central banks, with interest rates in the main advanced countries staying low. We have been critical of the central bank forecasts of low inflation and a quick reduction in the higher inflation they currently reporting, but have noted they have always wanted to keep rates low and promote a faster and wider recovery.

QE removal to accelerate

The latest change of message from the Fed implies earlier removal of quantitative easing, which would mean the opportunity to raise interest rates sooner than the old plan. The worries about the virus also should act as some restraint on the more hawkish elements on Monetary Policy Committees as they consider the negative effect on growth which even moderate restrictions on social contact and freedoms could have.

It does not make a lot of sense to raise rates before ending quantitative easing, as the point of buying up more government state debt is to keep interest rates low and credit plentiful through keeping the commercial banks liquid. Any central bank thinking it needs to raise rates to send a signal to markets that it is taking inflation seriously would be wise to wind up its money creation programme first.

It does not make a lot of sense to raise rates before ending quantitative easing.

The Fed was thinking of buying bonds until the middle of next year and may now want to end the policy in the first quarter of 2022 instead. Maybe the Fed chair hopes that his change of tone and words may do something to calm market fears of inflation and head off too much transmission into wages.

Vaccines the key

Our central scenario also assumes vaccinations will contain the serious case rate and death rate from the various shapes of the Covid-19 virus, allowing the northern hemisphere to get through the winter without a widespread and comprehensive lockdown. We have always assumed there would be some local and regional hotspots and some continuing variable restrictions that fall short of closing down all hospitality, travel and entertainment again.

We await more medical evidence on how serious the Omicron variant is and whether vaccines work against it or not. There is no evidence yet to suggest this will be a more serious disease, nor that it defeats current vaccines. We would only shift to the bear case were new evidence to emerge that governments have to shut down large sections of their economies and were there to be no forthcoming substantial policy offsets to such a development.

As we review scenarios for next year, it still seems likely the world economy will muddle through, with continuing local and regional headwinds to growth from measures to counter the pandemic and with some general move towards a tighter monetary policy. In the main advanced countries Japan and the Euro area are likely to keep rates around zero, whilst the USA will be looking to raise it short rates a modest amount once it has ended quantitative easing. Some of the smaller advanced countries have already commenced modest rate hikes without unduly worrying consequences for equity markets.

  • 6% US inflation rate

Jerome Powell at the Fed is right to concern himself with the possibility of inflation becoming embedded, with an inflationary wage round reinforcing the supply shortage and energy induced price rises we have seen so far. That remains our worst bear case. It is good news that he wishes to arrest any such possibility.

Markets will now need to watch how it plays out as a more worried Fed takes on an economy which already has 6% inflation and where the labour market still has many more jobs than willing takers.

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Why markets have fallen

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