Investors and policymakers are in data dependent mode, especially given the current critical juncture of the global economy and the financial markets. Faced with broad-based price pressures driven by a host of exogenous factors, the US Federal Reserve has rapidly, though belatedly, raised rates in the first half of 2022 at the fastest pace since the early 1980’s, bringing the federal funds rate to 2.25-2.50% from near zero in March.
Latest US inflation data for July showed the Consumer Price Index (CPI) rose by 8.5% year-on-year, thus marking a greater deceleration in inflation relative to consensus expectations. Core CPI also came in slightly below expectations at 5.9% year-on-year. Even so, CPI details reveal that despite a slight moderation in energy prices, inflationary pressures remain robust, including ongoing increases in food and shelter costs.
Almost inevitably, the CPI number has elicited considerable debate about whether US inflation has peaked and what the implications might be for the trajectory of the ongoing Fed rate hike cycle. While some market participants believe the worst of the price pressures may be behind us, others are more cautious.
All said and done, the July CPI release is but one data point. One swallow does not a summer make. Indeed, US policymaker comments have remained resolutely hawkish in recent days.
For example, it is instructive to note that even the relatively dovish Fed speakers have espoused a continuation of aggressive interest rate hikes in the coming months. Minneapolis Fed president Neel Kashkari, long known as an uber-dove, has expressed the most hawkish of rate projections among his peers, by wanting to raise the Fed funds rate to 3.9% by year-end and to 4.4% by end-2023. Meanwhile, San Francisco Fed president Mary Daly said last week that it is too early to “declare victory” in the ongoing battle against elevated inflation, not ruling out a third consecutive 75 bps rate hike at the next FOMC meeting in September.
Whether some balance in the inflation vs recession tradeoff can be struck, remains to be seen. The Fed’s tightrope walk between engineering a bit of demand destruction to rein in inflation on the one hand, versus not slamming the brakes so jarringly that it would result in a hard economic landing, remains a tricky highwire act that does not have a successful precedent.
That said, the US economy is in a better place than most other major economies. In fact, a US economic soft landing still remains a possibility for now – the strong gains in non-farm payrolls in July and other key indicators suggest the US economy remains reasonably resilient even as doomsayers warn about stagflation or a meaningful (beyond the technical definition of two consecutive quarters of GDP contraction, which is already in place) recession.
The UK and Eurozone economies are worse off in comparison. For example, the Bank of England has raised rates to a new 13-year high with more tightening in store even as it projects the UK economy to enter recession in the fourth quarter of this year that will last through 2023. Meanwhile, the impact on the Eurozone has been especially severe given that the Ukraine-Russia conflict on its doorstep has led to an acute energy crisis that threatens to upend growth while fueling inflation, thus making the European Central Bank’s task extremely challenging. Even so, the ECB delivered a larger than expected 50 bps rate hike last month, thus ending an eight-year stretch of negative interest rates in one fell swoop.
China’s economy is also beset with many problems including Covid shutdowns, property sector slump, and geopolitical tensions – this confluence of negative factors has contributed to an economic slowdown that has led the central bank to deliver a surprise rate cut today.
What does all this mean for global allocations? For one, US exposure will remain sought in global equity and bond portfolios, with the greenback’s ascent, stemming from an aggressively tightening Fed, also lending an assist. At the same time, however, we believe volatility in the US markets will persist.
In fact, we believe that US equity and credit markets have become far too sanguine of late – this belief is based on the observation of how various US asset markets have been reacting to evolving data and policymaker comments in recent weeks. A case in point is how any data releases that hint of recession have been viewed as a positive for equities, as investors choose to focus on the premise that the resulting weakness in growth will lead the Fed to pause or halt its rate hikes. Clearly, given recent Fed speakers’ comments and underlying price pressures remaining worrisome , this premise appears to be deeply flawed.
On the contrary, the Fed’s double-barreled salvos of continuing rate hikes and quantitative tightening (reduction in the size of the Fed’s bloated balance sheet via asset sales such as mortgage securities and Treasuries) portend more pain and tighter liquidity. Further, uncertainty among investors and policymakers alike will keep volatility elevated.
Against this backdrop, taking directional bets in US markets remains fraught with danger. Instead, amid all the macroeconomic, geopolitical and Fed policy moving parts, there are expanded opportunity sets in a more tactical, relative value approach that focuses on mis-pricings and valuation overshoots in asset markets.