Over the past 25 years, global investors have become conditioned to the notion that central banks will bail out global asset markets amid the first sign of stress. Many of these occurrences have been when the economy has been firmly in expansion territory such as 1998 when the Russian default crisis and the collapse of LTCM saw the Fed cut rates during one of the biggest economic and speculative equity booms in recorded history. Twenty years (and a few months) later, the Fed was completing one of its slowest tightening cycles ever and decided to go on hold in early 2019 because the US equity market had declined -20% in Q4’18, and then they cut rates in September 2019 when US unemployment was at a fresh 50-yr low of 3.5%, which sparked a huge gain in the S&P 500, despite zero earnings growth.
Although there are numerous other examples of the Fed, in particular, bailing out markets in the past quarter century, all of these policy pivots were possible as their preferred inflation gauge, the core PCE, was close to the +2% target. In 2022, investors have once again formed an expectation that the Fed could pivot on policy and be easing rates as lower commodity prices means financial conditions may not need to tighten as much as previously thought to get core inflation back to 2%. This is a challenging notion as reducing inflation from 6% to 4% will be much easier, than from 4% to 2% without a recession.
In this paper, we examine more closely, why the market may be over-estimating the Fed's optionality.
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Recession risk and the audacity of hope
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
Thoughts on the Market: The Fog of War
2022 is not very old and already it has seen a stock market correction, a 50bp flattening of the US yield curve and a major geopolitical crisis in Europe. Investors are contemplating the potential consequences of the Russian invasion of Ukraine, and the direct economic impacts here are minor as the world’s trade and financial linkages with Eastern Europe are very low. However, the indirect impact through higher commodity prices (energy, metals, and food) to consumer’s purchasing power is far more significant and simply adds more impulse to already well-established upward trend in global inflation, as well as downside risks to growth.
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The two 'known unknowns' of 2022
In history there are decades where not much happens, and there are months where decades happen. Covid has had far reaching effects on how economies function, where we work and how firms do business, and that process is on-going.
While the dust has not fully settled, the early picture emerging in the post-pandemic economy is that household behaviour, labour markets, correlations between asset classes, and the sensitivity of all those factors to policy changes, have notably changed. These factors have, in turn, altered the growth and price trends in most economies, and this will have significant implications for risk and return dynamics within portfolios going into 2022 and beyond.
Thoughts on the Market
Vice President Biden appears set to be the 46th President of the United States, most likely with a divided Congress. A split Congress has two opposing effects on growth. On the positive side, it should mean that more centrist policies are likely to be pursued, all of which are constructive for growth. Conversely, a Republican controlled US senate is likely to pursue a material decline of the US fiscal deficit, which is set to underpin a large US fiscal drag in 2021.
Click here to read more on Perpetual Investments’ thoughts on the US economy amidst the change of Presidency and the surging pandemic.
Quarterly Market Insights - January 2019
Perpetual Investments
Please find below the new edition of the Quarterly Market Insights from the Multi Asset team at Perpetual Investments, which is a compilation of their thoughts and views of key issues in financial markets, the earnings and economic cycle, the interaction of policy makers, and how this affects investment goals.
The main points are as follows:
2018 will be remembered as a year where market volatility returned
The 2019 share market outlook is challenged as expectations remain elevated, growth is slowing across the world and margins are under considerable revenue and cost side pressure.
Global growth has entered its third deceleration phase of this cycle
After two years of above-trend growth, the global economy is set to return to a below-trend pace in 2019