Investment Idea

What will be the Federal Reserve's New Year's resolution?

07/12/2022 | 4 min read

A new year for the stock market is closing in, and the Federal Reserve's decision sets the mood for New Year’s Eve

It's approaching a new year on the stock market, and the Federal Reserve's decision sets the mood for the New Year’s Eve. The new year may offer slightly brighter results than the past year, which was characterised by high volatility and uncertainty. Over the past year, the Federal Reserve has maintained a hawkish tone towards the stock market and investors are hoping for an easing in monetary policy that could perhaps happen towards the end of the first quarter of next year. This especially if the Federal Reserves were to slow down on the rate of hikes which the market would see as a more dovish message on December 14.

The arguments against further hikes are many and it is highlighted that continued rate hikes are not sustainable based on the fact that inflation has fallen somewhat as well as a potential future slowdown in the economy. At the same time, the Federal Reserve has highlighted that inflation must fall steadily for an easing in monetary policy to occur and that it is prepared to continue raising until inflation comes down. Tight central bank tightening is leading to further increases in unemployment and perhaps lower inflation than the 2% target in the long run.

Core inflation, which excludes food and energy costs, may have been a driving factor for the current inflation rate, while the increase in inflation correlates with the sharp rise in energy and fuel costs. As a result of current developments and commodity prices, the dollar has been very strong, but there are now concerns that the strong dollar is hurting developing countries as well as the financing of many states whose loans are dollar denominated. Interest costs and uncertainty then tend to alter countries' investments in development and innovation, which may be underlined by governments' more cautious budgets with tax increases and austerity. Central bank approaches are not all equal and the effects of a Fed hike tend to be more lagged than those of the Riksbank, for example. This adds to the risk as hikes can take effect after a few months in a scenario where inflation has already fallen.

Of interest to Swedish investors is the spread between the Riksbank's policy rate and the US Federal Reserve's. A large spread leads, among other things, to a weaker krona and a lower proportion of foreign investment in Sweden. Therefore, it is also important for the Riksbank to follow the US central bank's decisions, but there is a limit to this tightening of monetary policy. It is difficult to determine where that limit is, but interest rate increases have a stronger effect on Swedish households. It is much more common to have fixed interest rates in the US for longer maturities of up to 20-30 years, while Swedish households tend to have floating three-month rates. Based on 2019 data compiled by the OECD, around 43% of Swedish households have mortgages on their homes, of which 69% have variable interest rates. In the US, 40% of households have mortgages but only 15% have variable interest rates. The short term means that an interest rate increase by the Riksbank is felt more quickly in the Swedish economy as the purchasing power of households is affected with higher interest costs and repayments. It may therefore be difficult to continue to increase with the current level of borrowing in society as the loan-to-value ratio is more suited to low interest rates.

Average Price/Earnings (P/E)- ratio for OMX, DAX and S&P 500 index  

Source: Bloomberg, OMX Index in SEK, SPX Index (S&P 500) in USD, DAX Index in EUR. Note: Past performance is not a reliable indicator of future performance.

In a situation where inflation is falling from high levels, equities tend to strengthen. However, there is a lot of uncertainty that is not priced into the stock market and rallies can happen quickly. Based on current levels on the OMXS30, companies are valued at high multiples compared to other European indices. Price/Earnings (P/E) ratios of 12-15x are otherwise what can be considered as more common valuations and based on that level, the Stockholm Stock Exchange is now reasonably priced. Whatever the valuation, investors are on their toes to be there when the tide turns. In addition, there is a willingness to move back to a Bull market which may also be one of the reasons for the relief rallies that have occurred over the past year. When US interest rates are released it is likely that the hikes will have an impact around 3-6 months later. The lagging effect can be exemplified in job statistics on the number of job vacancies and the proportion choosing to quit. Based on that, a stock market rally could occur sometime in quarter one or two of next year with rallies in between.

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At the same time, one should not think that inflation cannot increase from current levels. It may also be very likely that inflation will come back after a short downturn, as some macro analysts point out. Having the right tools in the bag is important where both long and short positions can be used to generate returns in this investment climate, partly to hedge capital when the macro arrives, but also to increase or decrease currency exposure in one's foreign assets.  

With Vontobel's products it is possible to get both long and short exposure to indices, equities, commodities and crypto. This is a unique opportunity and a growing approach to investing. Leverage allows you to expand your potential gains, but if the underlying benchmark moves in the opposite direction, the potential loss is also increased. Hence, one should be aware of their positions as well as how the various products work. In addition, one should also be prepared for a total loss of the invested capital. Leverage increases risk, but many people have some type of leveraged investment. For example, if you own a house or an apartment and have taken a mortgage you get leverage on your purchase. If the value of the property is 3,000,000 SEK and mortgaged at 2,000,000 SEK you have a leverage of 3 on the development of the value of the underlying property. If the value of the property increases by 16.6% to 3,500,000 SEK, the value of the investment is up 50%. Exchange-traded products also come with risks and costs. As an investor, you pay a spread like buying shares, as well as the costs of holding a product. You can find all products and product information under the product tab.


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