Will the Fed Ruin the Party?
September 7, 2022
Harmen Overdijk, CFA
Global Bonds Experience Their First Bear Market in a Generation
Global equity and bond markets started August on a positive note, but sentiment turned as investors’ attention shifted from recession fears to Fed hawkishness, which caused most asset classes to give up recent gains. Many investors focus on equity markets but the hardest hit market this year is the bond market. The Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds has fallen more than 20% below its 2021 peak, the biggest drawdown since its inception. Officials from the U.S. to Europe have hammered home the importance of tighter monetary policy, building on the strong hawkish message from Federal Reserve Chair Powell at the recent Jackson Hole symposium. Soaring inflation and the steep interest-rate hikes deployed by policymakers in response have ended a four-decade bull market in bonds. That has created a particularly difficult environment for investors this year, with bonds and stocks sinking in tandem.
The Market is Starting to Believe That the Fed is Serious
Meanwhile, the performance of equity markets in August is a tale of two halves. Most major global equity indices rallied in the first two weeks of the month. Evidence of easing price pressures coupled with signs of deteriorating demand conditions encouraged investors to bet that the Fed will soon be forced to abandon its hawkish stance. However, the rally reversed as it became increasingly clear that the Fed remains committed to bringing inflation back down to target. Investors are now wondering whether that was only a bear market rally. It could be but, in our view, it is more likely that the S&P 500 will remain in a volatile bottoming process.
This recent market correction was caused by the market realization that the Fed is more hawkish than what most market participants, unscathed by the inflation of the seventies and eighties, so far believed. There is a meaningful divergence between the Fed Funds Rate expectation, derived from the OIS curve, which represents the swap market’s expectations for future interest rates set by the Fed, and the “dot plot.” The Fed’s dot plot is a chart that records each Fed official’s projection for the central bank’s key short-term interest rate, currently predicting rates could be raised to 3.6% to 4.1% over the next six months. To convince the market, multiple Fed governors stated in their speeches that the Fed will not cut rates in the first half of 2023, and rates will stay higher for longer.
Chairman Powell reiterated this stance during his Jackson Hole speech: While he acknowledged that there are early signs of inflation abating, he affirmed his commitment to combating inflation by maintaining tighter monetary policy, even if that brings about some economic pain.
In addition to higher rates, in September, the Fed is scheduled to reduce its balance sheet by a maximum of $95 billion from $47.5 billion, further tightening financial conditions.
What is Jackson Hole and Why Does it Matter?
Jackson Hole is a town in Wyoming where the U.S. Federal Reserve every year organizes an economic conference that attracts many of the world’s central bankers, policymakers, and economists.
The conference has been organized since 1982 by the Kansas Federal Reserve. When officials sought a location for an annual economic symposium, they chose Jackson Hole, Wyoming, for a simple reason: It had fly-fishing. Paul Volcker, the Fed chairman at the time, was known to enjoy the pastime, and it was hoped that the opportunity to do some fishing would draw Volcker away from Washington, D.C.’s late August heat. It worked, and the Fed has held a conference there in late August ever since, attracting top global policymakers.
Guidance from this year’s Jackson Hole conference was loud and clear: Central banks are committed to ensuring that inflation returns to target. Powell started his speech by highlighting that the Fed’s “overarching focus right now is to bring inflation back down to their 2 percent goal.” Moreover, he stated that they are purposefully moving policy “to a level that will be sufficiently restrictive” and that “estimates of longer-run neutral are not a place to stop or pause.” At 2.25%-2.5%, the fed funds rate is already within FOMC participants’ range of estimates of its longer-run level (2%-3%). These comments underscore that the Fed will continue tightening policy further. He also left the door open for another 0.75% rate hike in September, highlighting that a single month of moderating inflation is not sufficient evidence of easing price pressures. Moreover, Powell indicated that the FOMC intends to keep the policy rate at restrictive levels “for some time.” He noted that “the historical record cautions strongly against prematurely loosening policy” and suggested that by acting with resolve now, the Fed may be able to avoid the lengthy period of very restrictive monetary policy that was needed to tame inflation in the early 1980s. The takeaway is that Fed policy is unlikely to change course from tightening to easing next year. This is a clear disagreement with the market’s pricing of a policy pivot in 2023.
Strong Fed Credibility
Even though headline inflation is running at over 8% and most measures of core inflation are in the vicinity of 5%-to-6%, the 10-year bond yield still stands at 3.2%. A key reason that helps explain why bond yields have failed to keep up with inflation is that investors regard the Fed’s commitment to bringing down inflation as highly credible. The TIPS market is pricing in a rapid decline in inflation over the next two years.
Despite its credibility, there is always a risk that the Fed could make a mistake. Inflation has risen rapidly, but there are good reasons to believe that inflation could disappear just as quickly. Under Powell’s leadership, the Fed arguably made several questionable judgment calls in the past few years. In 2018 the Fed started tightening at a time the economy was slowing, while in 2021, the Fed was expanding its balance sheet while there were already clear signs of accelerating inflation. In both cases, the Fed had to reverse course completely in the year after.
Why Are We Still Positive on the U.S. Economy?
We remain constructive on the economic outlook as we believe employment markets are still very strong, as evidenced by last week’s strong U.S. employment data. This, in our view, will keep a recession at bay for much longer than the market expects.
Next to a strong employment market, another important factor is the fact that U.S. households have accumulated $2.2 trillion (9% of GDP) of excess savings since the start of the pandemic, most of which sit in liquid bank deposits. Admittedly, most of these savings are skewed towards middle- and upper-income households who tend to spend less out of every dollar of income than the poor. Nevertheless, even the top 10% of income earners spend about 80% of their income. This suggests that most of these excess savings will be deployed, supporting consumption in the process.
Inflation is the Key
We believe that inflation will fall significantly over the coming months because of lower food and energy prices and easing supply-chain pressures. The GSCI Agricultural Index has dropped 24% from its highs and is now below where it was before Russia invaded Ukraine. Retail gasoline prices have fallen 25% since their peak in June, with the futures market pointing to a substantial further decline over the next 12 months. In general, there is an extremely strong correlation between the change in gasoline prices and headline inflation. Supplier delivery times have also dropped sharply.
Falling inflation over the remainder of the year, thanks to the unwinding of supply-chain dislocations, will lift real wage growth, improve consumer sentiment further and, in turn, lead to more spending. These dynamics could help the U.S. economy avoid a recession and imply that stocks still have upside. This supports our constructive view on equities for the remainder of this year.
Falling inflation could sow the seeds of its own demise, however. As prices at the pump and the grocery store decline, real wage growth will turn positive. That will bolster consumer confidence, leading to more spending. Core inflation, which is likely to decrease only modestly over the coming months, will start to accelerate in 2023, prompting the Fed to stay hawkish, which could lead to a recession further down the line.
The Euro is Undervalued
After Russia suspended natural gas deliveries to Europe indefinitely, Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two LNG terminals. Germany has also postponed plans to close its nuclear power plants and has approved increased use of coal-fired electricity generators. France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government could raise output from its large Groningen natural gas field, which still holds at least 60 billion cubic meters of gas.
At this point, it looks like both the UK and the Euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch as Spain imports a lot of LNG while France has access to nuclear energy. Both countries also have fairly resilient service sectors, while Italy and Germany are more dependent on industrial production.
The good news is that even in the most troubled European economies, the bottom for growth is probably closer than widely thought. Even though imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years. It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting. All this suggests that Europe could be headed for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, would likely rally on the back of this.
China’s Housing Market
A weak housing market will remain a major drag on the Chinese economy in the near term. In many respects, the Chinese housing market resembles the Japanese market in the early 1990s. Just as was the case in Japan 30 years ago, Chinese household growth has turned negative. The collapse in the birth rate since the start of the pandemic will only exacerbate this problem. The number of births is poised to fall below 10 million this year, down more than 30% from 2019.
As the largest source of developers’ financing, home sales (including deposits & advance payments, and mortgages) have accounted for 50% of real estate developers’ total financing in recent years. Developers will continue to be deprived of liquidity without an improvement in housing sales. The lack of financing for homebuilders will continue to depress housing construction. The RMB 300-400 billion bailout will not provide adequate financing for overall property construction. Furthermore, the property industry in China is very fragmented, making bailouts difficult to organize and execute. Chinese authorities are stepping up policy easing measures to halt the slumping property market. Nevertheless, the recent 0.15% interest rate cut may not be enough to revive housing demand given the uncertainty over household income growth and worries about whether developers can complete projects and deliver housing units.
It will take time for a recovery in sales and construction activity to occur, because of the excesses in the Chinese property market. A weaker Chinese property market would help restrain commodity prices, easing inflationary pressures in the process. As long as the Chinese banking system does not implode, which we think is highly unlikely given that the major banks are all state-owned, global investors might actually welcome a modest decline in Chinese property investment. A weaker Chinese economy with less construction could have a deflationary impact on the rest of the world.
Markets
What should investors expect given the uncertainty in all asset classes? In our view, sentiment has become very negative and is fully focused on Central bank hawkishness. Although rising interest rates are a risk to economy, the market seems to be ignoring the current strength of the economic data. A different market risk could be geo-political. The Ukraine war is ongoing, a new Iran deal is highly uncertain, and a collapse of talks could lead to further instability in the middle east, while tensions over Taiwan are still high.
Portfolio Positioning
Given the uncertain outlook, we favor a neutral portfolio position. The fact that sentiment is so negative means markets could also surprise on the upside when economic growth remains stronger than expected while inflation pressures dissipate in the coming months, as we expect to see. However, we recognize the combination of uncertainties will probably lead to sustained high volatility in markets in the coming months.
As we believe the Euro and Pound Sterling have become very undervalued, we have actively hedged a significant part of the US dollar exposure in our Euro and Sterling-denominated core portfolios.
DISCLAIMERS & DEFINITIONS
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.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The S&P GSCI Agriculture Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark for investment performance in the agricultural commodity markets.
The Barclays Global Aggregate Total Return Index measures the performance of global investment grade fixed income securities. This index is widely used as a benchmark for fixed income securities.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.