Roger [00:00:00] Some of the recent U.S. macro data has suggested that the economy might be more resilient than expected with the latest ISM Manufacturing and ISM services surveys remaining in expansion territory and the Conference Board Consumer Confidence Index beating expectations to rise from the previous month. While some feel that the recessionary outlook has been overexaggerated for others, the strong data outlines the very difficult choices that the Fed is going to have to make. So is the Fed caught between a rock and a hard place?
Roger [00:00:30] That's The Big Conversation.
Roger [00:00:37] The narrative for this year has been that higher prices would lead to a tightening from the Fed that would slow down the economy, leading to a recession that would then bring prices under control. At the same time, the market has also been expecting a policy reversal from the Fed at the first signs that the economy is under duress. Prior to the Jackson Hole speech by Chairman Powell, the small downturn in headline CPI and the deterioration of many regional economic surveys were sufficient for many to call for a pivot from the Fed, towards looser policy. At Jackson Hole however, Powell reiterated that their current battle is to fight high prices rather than support deteriorating growth. If the economy was to rebound now, that would mean that the Fed would have to lean even harder on rate hikes than the market currently expects because a rebound could mean the prices remain elevated for longer. Therefore, trying to work out the trajectory of rate hikes will depend upon how the sequencing of events unfolds. The first sequencing relationship is between price and growth, and the second is the impact of higher prices on households versus the large corporates. So first on price and growth. The Fed clearly pivoted towards concerns about price at the end of 2021. The market had anticipated this pivot, with U.S. 2yr yields, which are like a sentiment indicator for policy, starting to break higher from the beginning of October 2021. Despite the Fed reiterating their commitment to capping price, the market still harbours the belief that the Fed would switch back to supporting growth at the first signs of economic weakness. But sustainable growth would be nigh on impossible without prices being first brought under control. And this is the distinction between the period of moderation from 1990 to 2020 and the periods of higher price today, as well as the 1970s. During the era of moderation, growth led the way. Stronger growth eventually led to higher prices and then higher interest rates. But they were the consequence of growth. And as long as growth was outpacing price, then the Fed was happy to keep raising rates. Eventually, higher rates strangled the economy, which would slow down, and then the Fed would begin to cut rates into the recession to restart the economy. This led to the classic inversion, then re-steepening of the yield curve that we saw on numerous occasions during this period. Today, price is stifling growth. Prices are rising not because of organic growth, but because of restricted supply and the fiscal injections that were administered during the COVID pandemic. Because the recent rise in price has been in excess of the rise in growth. The market started to price the policy response of higher interest rates and higher yields. Therefore, these higher prices became an economic burden preventing true growth from taking hold. So if prices remain unconstrained today, the market will continue to tighten financial conditions in anticipation of the Fed's response. So far, the Fed has been lagging the market rather than the Fed being the aggressor. But until prices meaningfully drop back, the threat of either the market or the Fed or both, pushing up funding costs will continue to be an impediment on growth. Therefore, in order to support growth, you first need to cap price. And the second issue of sequencing, is the uneven impact of higher prices on the US economy. The slowdown has so far been centred around households and small businesses. The median household and many small businesses have probably been in a recession for some time. US real average weekly earnings have remained in negative territory for a while now and purchasing power across this large swathe of the US economy has been under pressure. The increased use of credit cards, for instance, is not a sign of resilience, but a reflection of shortfalls in household budgets. Monetary policy, however, is generally focussed on broad based economy. Large-cap corporations have greater pricing power than small family businesses, and they've been able to pass on many of their high costs so far. The ISM manufacturing index has remained in expansion territory and this makes the economy look better than it really is. And it mirrors in some ways the ISM during the 1970s when recessions often arrived when the ISM was above the 50 level. The latest ISM services data also surprised to the upside. U.S. earnings season was also an upside surprise because the worst of the current price shock has not yet been fully felt by the large-cap corporate sector. Margins have been maintained by passing on prices, while keeping wages relatively in check, but that might be the next shoe to drop. Workers are now demanding higher wages, and this will lead to one of two things or potentially both. Either margins will contract or companies will start to lay off workers, and this has already begun within the technology sector.
Roger [00:05:20] But so far, employment data has remained robust, though this is notoriously lagging. Initial jobless claims have started to tick up, but this is a tiny change compared to previous periods where claims started to rise. If they are going to rise for an extended period, then past experiences would suggest that the main bulk of recession is still ahead of us. The relatively strong jobs data is also a headache for the Fed. Rising wages are one of the main channels to turn higher prices into sticky inflation. So far, companies appear to be hoarding workers after struggling to fill jobs during COVID. But many of these jobs are at the lower end of the pay scale, with shortfalls experienced in the US and in Europe also, due to a lack of immigration filling many of these posts. Furthermore, many workers who had hoped to retire are now returning to work because of the impact that inflation has had on many portfolios. And there are many signs that people are taking multiple jobs to make ends meet.
Roger [00:06:15] Therefore, a tight labour market does not necessarily mean a strong labour market, but the Fed will still have to deal with the data that they're given, even if it is going to be prone to future revisions. And this is why a rebound in the economy does not help their cause. Growth would lead to higher prices, which would then lead to lower growth. Growth would be transitory, if inflation is not. If month-on-month CPI only remains flat for every month until year end, CPI will still be in excess of 6%. It could of course fall into negative territory on a monthly basis, but each rebound in the economy will help fuel demand and therefore price. And the US equity market has struggled since Jackson Hole and failed to bounce on the strong ISM manufacturing, presumably because yields also pushed higher under conditions of poor liquidity and quantitative tightening. The yield curve has steepened a bit since the ISM manufacturing release, because 10-year yields moved more than 2-year yields in anticipation, that growth might not decline as much as expected. Higher yields helped to tighten financial conditions, and equities struggled last time that yields were approaching 3.5%, as they are today. But what the Fed really needs to manufacture, is a much deeper inversion, where 2-year yields are much higher than 10-year yields. This would occur if the market expected more tightening from the Fed than is currently priced in. In that case, growth prospects would be expected to fall. Back in the 1970s, the inversion reached in excess of 200 basis points. So far this year it's briefly reached -50, but the Fed probably needs to be far more restrictive. Furthermore, the Fed has rarely pivoted whilst interest rates are below CPI. Today the gap is still huge. Either inflation has to fall significantly or the Fed has to do a lot more lifting in order to cap those prices. In fact, the Fed may need to break something, hence the rock and a hard place. The better the economy, the more the Fed will have to shock the market in order to get prices back under control. They may need to engineer a recession. And yet the market wants the Fed to reverse course at the first sign of recession. And if they did that, they would almost certainly fail in their mission to cap prices. And yes, a recession has always led to a decline in inflation, but mainly because employment has started to shift higher. Employment has not, as we've seen, started to move in a meaningful way. And the ISM data suggests a full-blown recession may be still some way off.
Roger [00:08:40] And there is an optimistic outlook, in which we get a natural subsidence in inflation because supply chain bottlenecks begin to ease. If during this time the economy remains intact, then we could see a soft landing. But it's unlikely that this is the base case for the Fed. Supply chain bottlenecks at ports can easily be cleared. Lack of investment in extraction facilities for many raw materials cannot. And this is all taken place when China has moved into an even more extreme state of lockdown. Eventually, China will reopen. Whilst this may further help to clear some of the supply chain bottlenecks, it will also increase demand for many commodities. So China reopening is yet another double-edged sword for the inflation outlook.
Roger [00:09:21] Now, perhaps the US economy could also be subdued by weakness across the global economy, where Europe is clearly under a lot of pressure. The impact of prices on households and the consumer in Europe is far worse than in the US and is probably about to get even more critical during the next few months. Energy subsidies are being arranged, but subsidies create other distortions or kick the can down the road to be socialised into lower future aggregate consumption and then stickier inflation as well. In short, today's short term remedies create long term drags, but most roads lead to the Fed sticking with their battle against price. If the economy picks up, prices will pick up, which will immediately cap growth. And that's because the market will again assume that the Fed is behind the curve and it will start pricing for higher interest rates. The whole yield curve shifted higher on the stronger ISM services data, amidst that poor liquidity backdrop in the market. Therefore, the Fed may need to guide the market higher in terms of rate expectations and, or, guide them towards interest rates, which remain higher for longer, so we don't get an immediate rebound in prices as we saw throughout the 1970s and early 1980s. This probably means that the dollar has to go higher, and whilst this has become a consensus trade, as we discussed in the previous episode, China has become key and China has been letting its currency decline recently. Dollar yen has also made a new high through 144 because the squeeze higher in global bond yields has again put pressure on the Bank of Japan to defend its own yield cap of 25 basis points. And if the ECB tightens policy, it does so from a position of extreme weakness. Higher European interest rates should not be supportive of a currency when the region is faced with so much energy uncertainty. In Europe's case, higher interest rates should have a similar impact to higher interest rates in emerging markets, where the currencies tend to fall because those rate hikes are coming at a time of economic weakness. And whilst it may be harder to justify a long dollar position today for an outright directional play, given the recent gains, it should be considered as a hedge.
Roger [00:11:23] Europe, China and Japan are all struggling to contain weaknesses in their currencies. Global cross-border dollar denominated debt remains at record levels, in excess of 12 trillion USD on balance sheets and potentially double that off balance sheet. These positions are all effectively short dollars, because it requires more and more local currency in order to pay off the interest requirements. Whilst US government bond yields have recently been rising, that's not certain going forward, even if the Fed does become more hawkish. If the Fed pushes rate expectations higher than they currently are, then the outlook for growth should fall. 10-year yields should stagnate or drop, whilst 2-year yields could make new highs. So we should expect the spread between the two to reach levels seen during the last inflationary shocks of the late 1970s.
Roger [00:12:07] And equities are a bit of a conundrum. If the Fed was to pivot, then equities would probably be a buy. But historically, they've tended to turn only after the pivot, not before. And the Fed doesn't look like it wants to pivot yet. Tech stocks have generally ebbed and flowed with yields when yields are rising. Tech stocks have tended to underperform. But what if 10-year yields fall, but 2-year yields rise? Well, that would probably lead to a correlation event across the equity market where all stocks are falling. And even the recent winners, such as energy, would struggle if we got that sort of event where equities have a higher volume decline. Roughly 70% of all major sell-offs have seen the biggest decline in the last third of the event rather than the first third. And that asymmetric downside risks are probably therefore still ahead of us, even though it is becoming a very consensus view. But there remains a disconnect between sentiment, which has been very negative, and positioning, which has so far been less so. Retail have been far more invested, even as institutional money has pushed cash onto the sidelines. Perhaps a better location for equity shorts, however, is Europe, where the Eurostoxx50, has not even retraced 50% of the rally off the COVID lows. It's difficult to see how Europe is in better shape today, than it was back in 2020, when the shutdown was at least controlled. Rate hikes by the ECB will exacerbate today's issues, and they may well need to be aggressively buying bonds to prevent spreads from blowing out. And that could put further pressure downwards on the Euro. For the Fed, the policy response from the government, may also require additional monetary tightening. So far, almost every government that has an inflationary problem has been looking to provide more fiscal support, which is one of the key factors in creating the price problem in the very first place. So they are fighting fire with fire, the Fed may therefore need to bring an even bigger hose.
Roger [00:13:59] So in summary, this is clearly a very tricky environment with exogenous factors compounding domestic issues in many regions. The sequencing of events has been impacted by the enormous distortions of the pandemic era. Certain parts of the economy, like the median household, have probably been in recession for an extended period. Employment, on the other hand, still looks robust, at least superficially. The Fed won't want wage inflation to seep into the data, however, because that risks a prolonged bout of higher prices. But if the Fed pivots to support growth, before prices have rebased lower, then prices will rise again, and growth will be stifled before it can sustainably take hold. Therefore, the Fed may well need to tighten into the teeth of recessionary events. In fact, a recessionary event may be the best opportunity to tame those higher prices. And recessions are a reset, and that may be required to restart the economy on a sustainable footing.
