The Policy Path Ahead
It is rare to see two consecutive weekly declines of –5% in the stock market. We have unfortunately witnessed this negative outcome in the last two weeks. And sentiment remains bearish through this week as well.
We share some thoughts on the –11% decline in the S&P 500 index since September 12. We focus on 3 events that have catalyzed the most recent decline in stock prices – the August inflation report, the September Fed announcement and the surprise fiscal stimulus from the U.K. government.
Markets were initially jolted when CPI inflation data for August surprised to the upside. On September 13, headline inflation came in at 8.3% instead of 8% and core inflation rose by 6.3% instead of 6%. Core inflation also showed a monthly gain of 0.6% instead of the consensus 0.3% expectation.
The higher-than-expected inflation data increased the odds of larger and more frequent rate hikes from the Fed. As much as investors may have geared up for a hawkish Fed, they were still taken aback by the tough Fed policy message on September 21.
The Fed projected that short term rates would rise to 4.4% by the end of 2022 and 4.6% by the end of 2023. And they expect their favored inflation metric to subside to almost 5.5% by year-end 2022, then to around 3% by 2023 and to just above 2% by 2024.
The Fed projections themselves were not too different from market expectations. For example, the market had priced in short rates of around 4.5% next year; the Fed was just a touch higher at 4.6%.
But what may have caught the markets by surprise was the Fed’s ultra-hawkish tone in continuing to fight inflation at any cost. The Fed essentially committed to an additional 150 basis points of rate hikes in the coming months without due regard to “data-dependency”. In the process, the Fed came across as prescriptive and mechanical as opposed to thoughtful and deliberate.
The U.K. Government
The new U.K. government announced a sweeping program of tax cuts and investment incentives on September 23 to boost the country’s faltering economic growth. However, the proposed plan set off several unintended consequences that now pose a greater risk to global markets.
A “loose fiscal, tight monetary” policy has historically led to weaker asset prices. The currency and bond markets in particular reacted violently to the misguided fiscal stimulus in the face of already rampant inflation.
The British pound declined sharply to record lows as investors worried about even higher inflation. The increase in the debt burden also sent long term bond yields to well above 4%.
The combination of the Fed’s hawkish posture and the U.K. fiscal plan sent the dollar soaring by 4%, the 2-year bond yield higher by 30 basis points and the 10-year bond yield climbing by 50 basis points to almost 4%.
The parabolic rise in the dollar and global interest rates create additional risks to the global economy. We assess them in the following framework.
- Given the growing evidence of a global slowdown and cooling inflation in the U.S., the Fed may now be approaching a stage of raising rates “too far too fast for too long”. We believe that a rigid and inflexible approach to continued tightening by the Fed may not be optimal.
- We advocate an impactful but yet measured and flexible policy path forward. We believe that inflation has peaked and is slowing down meaningfully to afford the Fed enough flexibility in the pace and frequency of future rate hikes.
- Our view on inflation peaking and now subsiding is supported by several metrics – copper, lumber, gasoline, house prices, mortgage rates, rents, tax receipts.
- Absent a shift in positioning, the risk of a Fed policy misstep is now higher. We believe it will eventually be avoided.
- We believe the sharp rise in long term U.S. bond yields is unsustainable especially in the face of declining inflation and demand destruction. Lower bond yields will likely help ease the strain on growth and valuations.
- Future rate hikes from the Fed will likely continue to slow growth and increase the magnitude and duration of a potential economic and earnings recession.
- The increased odds of a recession are already reflected in the new lows that have been created in the stock market this week.
- Unless the Fed blunders into a major mistake, we do not expect a deep and protracted recession or a lengthy bear market.
- We continue to hold existing equity exposure, slowly deploy un-invested cash into growth assets in public and private markets and explore ways to create tax alpha from tax loss harvesting.
These are extraordinary times of change, challenge and chaos. We stand ready to help you navigate this unusually high market volatility.