Fed indecision puts US above China as top source of market uncertainty

• Concerns about China have ebbed amid measures to shore up the economy and investors turning increasingly bullish on Chinese stocks
• Meanwhile, the Fed is flailing as valuations in US equity and bond markets are dangerously stretched and inflation is the highest in decades

When it comes to policy surprises, few countries have unsettled investors more than China in the past few years. President Xi Jinping’s “common prosperity” campaign, designed to spread the country’s wealth and purge the economy of capitalist excesses, caught even the most seasoned China-watchers off guard.

Investors and businesses have been left wondering where regulators might strike next. They are unsure whether the government’s pain threshold – the willingness to tolerate slower growth and market volatility in the interest of promoting longer-term stability and reducing inequality – in the all-important property sector is higher than assumed.

These concerns have ebbed somewhat in the past few months. A change in tone on the part of Beijing, underpinned by a series of measures to help shore up the economy, has raised expectations of a policy-induced rally in Chinese assets. Several major financial institutions have turned bullish on Chinese stocks, partly because of attractive valuations.

The threat of more severe financial contagion in the real estate sector continues to be a source of concern for global investors. Yet, even at the height of the sell-off in junk-rated Chinese dollar-denominated debt last November, it never topped the list of major risks in markets, according to the findings of Bank of America’s monthly fund manager survey.

Since the beginning of last year, the surge in inflation and the risk of a disorderly sell-off in bond markets have had a far more detrimental effect on broader sentiment than the mounting stress in China’s corporate debt market.

While the unpredictability of Beijing’s regulatory interventions inflicted severe damage on offshore Chinese stocks, fuelling a heated debate over the investability of the country’s equities, the dramatic increase in policy uncertainty in the United States has diminished the importance of risks in China.

The decision last month by the Federal Reserve to take more forceful action to quell inflation has opened a Pandora’s box. Not only has it called into question the credibility of a central bank that had previously played down price pressures, it has increased the risk of a major policy mistake and accentuated the severe economic and political challenges faced by US President Joe Biden.

The Fed has pledged to begin raising interest rates sooner and more sharply than anticipated while at the same time insisting it needs to be “humble and nimble” in its efforts to normalise policy. The resulting confusion has reinforced the perception of an indecisive central bank caught between the Scylla and Charybdis of high inflation and slowing growth.

In a sign of the extent to which markets are struggling to predict how fast and far the Fed will tighten policy, the anticipated number of rate increases this year ranges from three to seven. The uncertainty has unleashed a wave of volatility in markets.

Having suffered its weakest January since the depths of the 2008 global financial crisis, the benchmark S&P 500 equity index has just enjoyed its biggest four-day rally since November 2020.

The Fed-induced turbulence in markets could not come at a worse time. Not only are valuations in US equity and bond markets dangerously stretched, borrowing costs are at record lows and inflation is running at its highest level in four decades.

The combination of all these factors makes further volatility inevitable, exacerbating tensions between markets and the Fed.

Moreover, the pressure on the Fed to tighten policy in the face of a sharp pandemic-driven slowdown attests to the daunting challenges faced by Biden. The surge in inflation has contributed to a drop in the president’s approval ratings, with about two-thirds of respondents to a CBS News survey last month claiming Biden is not paying enough attention to high prices.

Political risk, although difficult for investors to assess and price accurately, is rife in America. Biden’s presidency has begun to resemble Jimmy Carter’s in the late 1970s.

Soaring inflation, domestic political paralysis and rising geopolitical tensions are all redolent of the problems that led to Carter’s defeat in 1980 at the hands of Ronald Reagan. However, the US is far more polarised at this time, and the Republicans remain the party of former president Donald Trump.

With the Democrats expected to lose the midterm elections in November, a more forceful attempt on the part of Republicans to sabotage Biden’s presidency looks likely. Although it is hard to see Trump mounting a successful bid for the White House in 2024, it is easy to see how Trumpism could destroy Biden’s presidency.

These policy and political risks, inextricably linked by the inflation shock, make for a highly unpredictable outlook. As China prioritises stability and takes measures to restore confidence in the economy, the US is heading down a perilous policy path with which markets are only beginning to come to terms.

Author: Nicholas Spiro is a partner at Lauressa Advisory, SCMP