With the recent discussion about the risk of a global recession, the below looks at the following points and examines them more closely.
• Only a few weeks ago there was a “hope trade” in markets that the Fed will back off the rate hikes in the September quarter. However, extremely high inflation, very low unemployment, and very late policy tightening means central banks are not in a position to pivot on policy and bail out markets like the Fed did in 2016 and 2018. This would only occur if they have made a mistake as evidenced by a sharp slowing of economic growth or the S&P 500 declining through 3,500. Neither of these are evident at present, and central banks need to continue moving rates higher to lessen the heat from very tight labour markets.
• Although fiscal and monetary stimulus is finally being wound back, a major misalignment persists between 40-yr highs in inflation, 40-yr lows in unemployment and real interest rates close to historic lows. Central banks are well behind the curve, but Morgan Stanley estimates that the tightening in US financial condition in the past six months is equivalent to 2.5% in Fed Funds equivalent terms, albeit from incredibly low levels. However, over the past 25 years financial condition at current levels have not sparked a material decline in inflation in the subsequent two years outside the severe recession which occurred during the 2008/09 GFC. This suggests that firstly rates need to go materially higher and, secondly that the Fed does not have the optionality to pause.
• The key for markets and investors moving forward is what happens to inflation, and there is no clear path here, but at present real cash rates are far too low to see core inflation back at 2% within the next few years. There is considerable cashflow pain ahead for households given higher energy and food prices, in addition to central banks having to tighten policy to get growth materially sub-trend. This is needed to have inflation within the realm of the typical 2% target by 2024, and rate hikes this year will weigh on activity in 2023 where recession risks seem much higher than what they are for the remainder of this year