by Paul Hoffmeister, Chief Economist
Recent market sentiment shifted for the worse on August 26 when Jerome Powell delivered his much-anticipated policy speech at Jackson Hole.
We continue to expect more pain ahead for financial markets.
There’s a long list of things to worry about that pose risks to the financial system. Europe may be the biggest one today.
Growing economic risks and improving forward-looking inflation indicators suggest now is the time for a Fed pivot.
Fed Outlook Remains Hawkish
Recent market sentiment shifted for the worse on August 26 when Jerome Powell delivered his much-anticipated policy speech at Jackson Hole. The Federal Reserve Chairman signaled that interest rates will go higher and stay there for longer in order to extinguish the 40-year high in inflationary pressures that have bubbled up during the last year.
He said, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”[i]
Powell explained that the FOMC’s policy deliberations are predicated on three lessons from the 1970s and 1980s. First, “central banks can and should take responsibility for delivering low and stable inflation.” Second, “the public's expectations about future inflation can play an important role in setting the path of inflation over time.” Third, “we must keep at it until the job is done.”
Unfortunately, the recent economic data suggests that the Fed’s job isn’t close to done. Last Friday, the Bureau of Labor Statistics announced that the U.S. unemployment rate fell from 3.7% to 3.5% in September, a multi-decade low. And based on August’s numbers, the CPI is rising 8.3% year-over-year. We’ll learn about September’s CPI number later this week; many are expecting it to fall slightly to 8.1%.
With this combination of a strong job market and unacceptably high inflation, the broad market perception is that the Fed is unlikely to pull back from its aggressive policy posture anytime soon. Understandably then, the S&P 500 is down more than 13% (not including dividends) since the day before Powell’s speech in August… and more than 20% year-to-date. The Nasdaq composite is down more than 30% year-to-date.
More Pain Ahead
As we’ve said numerous times this year, we’re worried that the Fed will continue raising interest rates and maintain those high rates until something breaks in the global economy.
There’s a long list of things to worry about that pose risks to the financial system: the UK and Japan are struggling with abnormally weak currencies that might spiral into currency crises, Europe may be entering a deep recession, real estate and banking risks continue to manifest inside China, and the Ukraine war may escalate following the sabotage of the Nordstream pipeline and Russia’s annexation of four regions in Ukraine. All the while, businesses and individuals around the world are being squeezed between higher costs and less revenue and income growth.
In our view, the top economic risk today is Europe. As of last week, the spread between 10-year Italian and German government bonds reached multi-year highs. This arguably reflects concern about the coming winter when the economy could come under severe stress due to high energy prices and the possibility of geopolitical tensions rising even further. The Russian army, which has mobilized an additional 300,000 soldiers and seems to be fortifying its positions in Eastern Ukraine, could pursue an aggressive, westward offensive across Ukraine to the Polish border.
Time for a Fed Pause
Even though inflation is unacceptably high and must come down, we believe the Fed does not need to be so aggressive and should pause now.
The current funds rate target range is 3.00%-3.25%, and according to the Chicago Board Options Exchange, futures markets are suggesting a greater than 80% probability of the target range being raised 75 basis points at the FOMC’s next meeting on November 1-2.
Within the next few months, we expect the entire Treasury curve between overnight T-bills and the 10-year to invert, indicating a strong chance of recession and a greater likelihood of an economic or financial crisis.
Pushing the economy into a recession looks unnecessary to us. Forward-looking indicators such as the 5-year breakeven and gold appear to be showing inflationary pressures significantly subsiding since April. The market is now expecting CPI to be closer to 2.55% in 5 years; whereas in April it expected more than 3.70%. During the same time, gold has declined from nearly $2000 to $1700. These are not signs of a lurking inflation monster.
Fed policy today appears to be guided by backward-looking economic data. Already, with the recent declines in gas, hotel and used car prices, as well as airfares, it appears that we’re seeing evidence of peaking inflation.
With precious metal prices such as gold on the decline, there is arguably little monetary-related inflation embedded in the current inflation statistics. Instead, most of the 5-8% inflation that the US economy is experiencing today is likely due to the myriad and highly complicated supply chain disruptions that have emerged due to changing US-China trade policies and Covid lockdowns, not to mention the war in Ukraine.
Time is required for normal price discovery to rebalance supply and demand for goods and services; in other words, supply shortages and higher prices will attract more producers who will ultimately normalize a supply-demand imbalance and thereby reduce prices, and vice versa. Arguably, a more stable economy that is not being exogenously and negatively impacted by choking interest rates would allow the price discovery process to proceed more efficiently, as opposed to a weakening economy with increasingly sharp changes in demand that must be accounted for at the same time as supply dynamics. One variable is easier to deal with than two.
With the myriad and complex risks around the world, and forward-looking inflation indicators arguably benign, we believe now is the time for a Fed pivot.
The Fed is talking tough these days, which took a toll recently on stock and bond markets. Hopefully, declining inflation data will compel them to pause their rate increases sooner rather than later. The economy could find its footing, albeit at a weaker baseline, and financial markets might cheer. In that scenario, a “soft landing” could be realized. On the other hand, if Fed policy continues to be driven strictly by backward-looking indicators while significant economic risks exist around the world, then we fear that it will likely go too far and the economy will overshoot to the downside.
[i] “Monetary Policy and Price Stability,” by Jerome Powell, Economic Policy Symposium Jackson Hole, Wyoming, August 26, 2022.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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