The war between Russian and Ukraine has overshadowed a major financial development since the start of the year: the decision on the part of several major central banks to adopt a significantly less accommodating monetary policy. Following a 25 basis-point hike by the Bank of England on 3 February, from 0.25% to 0.5%, the Federal Reserve did exactly the same thing (and to the same level) in mid-March. Fed Chairman Jerome Powell said on that occasion that future hikes could be bigger and that the Fed would intervene as often as necessary, as the origins of US inflation were endogenous enough to trigger higher interest rates.
In the meantime, the war in Ukraine has fundamentally altered the nature of inflation in continental Europe. We have shifted abruptly from expensive energy (cyclical inflation) to energy scarcity (structural inflation), reflecting the fact that we will lose Russian supply in the short and medium term at least. We recall that Russian oil and gas accounts for 16% and 19%, respectively, of EU consumption. The European Central Bank’s 2% inflation target has already been overshot for the past nine months, precisely because of higher energy prices. Year-on-year consumer price inflation hit 5.9% in February and the problem is bound to worsen. The ECB’s own scenarios give us inflation rates of between 5.1% and 7.1% for 2022 as a whole and it has reduced its eurozone growth forecast for this year from 4.2% to 3.7%. Given that the war appears to be nowhere near ending, growth forecasts will inevitably be reduced further in the months ahead.
At the same time, divergent central bank approaches will have a real impact on the currency markets, injecting more volatility to international asset prices.
The best example is that of Japan, where the yen has depreciated 6% since the start of the year and 17% since the beginning of 2021, leaving it at its lows of 2015 and 2007. The reason is evident: the Bank of Japan’s clear desire to persist with unconditional support for the economy in general and government in particular via market intervention and extremely low interest rates. The resulting interest-rate differential with respect to other currencies has pushed international investors out of yen and into the UK, for example, and especially the USA. Both have made tackling inflation a priority and have unambiguously initiated tightening cycles.
At micro level, the American Q4 2021 results season ended on a strong note. S&P 500 earnings per share increased 31.5% over the year before, compared with a consensus forecast at end-December of 21.2% (source: FactSet). This made it the fourth consecutive quarter of 30%-plus earnings growth, a phenomenon that we have not seen since Q3 2010. That said, Q4 2021 saw the consensus outstripped by only 8.2% overall, compared with an average 8.6% over the past five years. We believe this signals the end of a trend of large flows of positive surprises over the past few quarters.
Against a backdrop of a widening GDP growth gap between the USA and Europe, with a healthier corporate sector in the former and a more helpful dollar exchange rate, we would argue that conditions have now been met for US equities to outperform their European equivalents once again in the short and medium term.
