Tightening Financial Conditions Are Causing a Transient Growth Scare
May 26, 2022
U.S. and Global equities are fighting three battles simultaneously – slowing global growth, higher cost pressures, and rising interest rates. U.S. financial conditions are tightening rapidly due to the Federal Reserve’s attempt to rein in inflation and thus fulfill its mandate for price stability. Apart from market-based inflation expectations metrics, the U.S. Financial Conditions Index (FCI) is a key indicator to monitor as it reaches certain historical levels that in the past proved to be policy pivot points for the Federal Reserve. In our view, the Fed’s goal is to tighten financial conditions enough to dampen consumer demand, but we do not see a U.S. recession as an imminent risk. Rather, we are witnessing a growth scare as the Fed is trying to engineer a soft landing in the U.S. economy.
The Financial Conditions Index (FCI) is a comprehensive index that is constructed using variables such as nominal interest rates, US dollar FX rates, money supply, equity valuations, and credit spreads; with weights that correspond to the direct impact of each variable on GDP. We note that the recent 0.5% rate hike saw Fed Chairman Powell mention the words “financial conditions” 16 times. In order to bring inflation under control the Fed’s goal is to slow down demand by tightening financial conditions sufficiently. Effectively, the Fed is pursuing demand destruction via negative wealth effects. Tighter FCI implies lower upcoming Fed Summary of Economic Projections (SEP) e.g. for GDP. Since the March Fed meeting, the GS FCI has tightened by 0.8%. Historically, a 1% FCI tightening reduced the Fed’s SEP GDP projections by 0.7%. The March SEP GDP estimate stood at 2.8% for 2022 and we expect the June Fed SEP GDP projection to fall to ~2%; which is much closer to long-term potential growth while also constituting one of the largest GDP downgrades by the Fed since 2007. Therefore, even though the Fed is determined to bring inflation expectations under control, we believe the FCI is a key data point to monitor as it can have a material impact on the Fed’s policy stance, and consequently on asset allocation. Further deterioration in FCI will likely signal peak Fed hawkishness and peak interest rates in the coming months.
As we can see below, investor positioning is now on the cautious side and U.S. equity valuations are not as demanding with several growth headwinds now being priced in. Adjusting for elevated volatility due to heightened investor portfolio hedging, we see a recipe for a strong market rebound as any hint of a Fed policy shift will likely sway investor sentiment to a more optimistic outlook i.e. in the scenario that inflation expectations come under control and recession risks recede.
We do not see elevated risks for an imminent recession as corporate and household balance sheets remain at very healthy levels. Moreover, the U.S. corporate profit cycle remains strong enough to elongate the current business cycle for at least 1-2 years. We also note that there are long time lags from when investors start seeing cracks in the profit & credit cycles until a sustained recessionary episode becomes evident. We believe this is exactly what the U.S. Treasury yield curve (3-month T-Bill – 10 Year Treasury Yield spread) is currently signaling i.e. at 178bps the yield curve is still quite steep and nowhere near signaling an imminent recession.
In conclusion, we view this year’s asset price volatility as a growth scare event that has emanated from the Fed’s resolve to bring inflation expectations under control by tightening financial conditions. By Q4 2022 we expect the Fed to signal a pause in its rate hiking cycle and one can envision a decline in cross-asset volatility. From a portfolio style perspective, we expect a market rotation back to “high duration” assets such as the 30-year long bond, long-dated municipal debt, high growth equity sectors (such as technology and consumer discretionary), and other rate-sensitive sectors such as communication services. Lastly, in this scenario, defensive sectors with premium valuations will likely underperform e.g. consumer staples.
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This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
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The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and “shadow” banking systems.