Investment Week published in their July issue a hypothetical view from the Endeavour Fund managers of the much sought-after ‘soft landing’ that could emerge in the US over the second half of the year (see here in our regular Trades features). We suggested it was a lot of ‘ifs’ and didn’t form a base case to the outlook, but we thought it might be useful to review the scenario laid out there and what has actually materialised since. We believe the trajectory in evidence offers a useful insight into how central bank policy and the economy may drive markets in the year ahead.
The past six months has seen inflation in the US fall by half the rate it was back then, and the most recent three month run rate indicates a possible further halving in the months ahead to nearer 3%. Bond market expectations for inflation are now firmly in the region of 2% for next year and beyond. It’s true that this time last year those expectations turned out to be way off the mark, but then war in Europe didn’t help. Oil prices are lower now than they were a year ago, other input prices and finished goods prices have abated too following an easing in the supply-chain, and small business pricing intentions have declined significantly. The Federal Reserve guided us this time last year that much emerging inflation would prove to be transitory. No one was able to define the speed or timeline of ‘transitory’, and the wording was readily dumped on the outbreak of Russia’s war in Ukraine. But even now much of the Covid-reopening inflation surge looks to have transited, even if only from goods to the services sector and stickier wage rises.
The US economy itself didn’t register a recession in the first two quarters of negative growth, at least not by official definitions, and indeed has accelerated somewhat through the second half. While goods prices inflation is firmly declining, the peaks we experienced a year ago did feed through into higher services inflation, as people wanted to get out and do stuff having been sat at home buying stuff. The corporate earnings seasons have surprised to the upside all year, and the third quarter in October was no different: even though the energy sector accounted for much of the upside, earnings gains were nonetheless evident in six out of ten of the main US industry sectors – in the Endeavour Fund equity holdings directly, 20% growth was delivered, and 10% excluding oil and gas holdings.
It seems the Federal Reserve’s policy of hiking rates this year at such an historically fast pace, while the economy had the strength and momentum to absorb them, was one of ‘better to arrive in haste than travel in hope’. This is in contrast to past inflationary cycles of the 1970’s, 90’s and 00’s. And it is something to bear in mind the time lag for those rate hikes to take effect: with progress on inflation already made from the first rate hikes in the Spring, there is a further 2.5% of interest rate rises already announced that are still due to land in the US economy in the months ahead, the UK and Europe being somewhat behind. The Taylor ‘rule’ of economics implies this has the potential to bring inflation as much as 5% lower in succeeding quarters. This will surely raise unemployment, by the same rule upto perhaps 4.5-5.0% in the US for 2023. This would still constitute a strong labour market by historical standards, with unemployment below the non-accelerating inflation rate, NAIRU, at around 6%. Maybe not so many jobs would have to be lost to achieve that, just fewer new entrants to the market securing that first hire.
This reduced inflation pressure primed markets from the early autumn to anticipate a change of tone from the US Federal Reserve, a change of ‘pace’ or maybe a ‘pause’ if not exactly a ‘pivot’ in their policy stance: bond market interest rates have fallen from their highs. As inflation falls, real incomes turn increasingly positive and as the economy and labour market cool but perhaps don’t’ crumple, it is conceivable that confidence starts to lift and strong balance sheets in households, corporates and the banking system remain at work and the business cycle moves on. This would come close to resembling the elusive soft landing.
A stark disconnect between US equity market optimism and bond market pessimism has now emerged, even if this does reflect their innately different outlooks and jobs in life: corporate profits thrive as high inflation falls, while bonds should always fear inflation and the destruction it wreaks on capital. The S&P500 stubbornly holds a high teens PE valuation on uncertain earnings prospects, and the bond markets firmly price recession and rate cuts within 12 months from now. The managers of the Endeavour Fund believe the ground between these two views is explained by the guidance of the Fed. As unlikely bedfellows they may be, equity markets and the Fed seem to be most closely aligned on a soft landing with inflation falling and activity slowing, though it may yet need a further nudge lower at some point later on. While bond markets are fighting them both for something harder: inflation is falling faster than we think, the Fed has already done enough, and guiding for yet more, they’re going to crash the economy.
There are two aphorisms often applied to the Fed: don’t fight it, and they always hike into a recession. The US Fed’s guidance last week for ‘a ways further to go’ and ‘the long haul’ seems to suggest they expect the economy will continue to grow but slowly and just enough perhaps (50:50) to avoid recession, but crucially here: that it will be drawn out long enough to keep the window open for just a small handful of further smaller rate hikes to restrain wages and other types of the stickier kinds of inflation out there.
This scenario therefore allows for a pause along the way. The Fed may just be right – don’t fight them – and yet, sooner or later, by definition, the last rate hike always is the one that tips the economy into a recession. But which is that last hike, is it much further away at the other end of this expansion, or have we already had it? The coming months of hindsight will tell. With all this inflation out of nowhere, we’ve somewhat forgotten the hard years and $trillions spent trying to bring it to life over the past decade, so central banks across the world might try to hang on to at least some of it if they possibly can, even if they can’t say that and risk losing their credibility again: consider Japan, 40 years on and positively gleeful with inflation at 2.5% and growing, with interest rates still firmly at zero and the entire bond market held captive in its policy of ‘yield curve control’.
The next round of inflation data is due this Friday in the US and again mid-January, with employment and confidence measures that will be significant too, before the next Fed rates meeting due in early February and the beginning of the Q4 earnings season. If recent trends continue, there’s an increasing chance a Fed pause is in the offing. Europe may avoid the worst of outcomes from a hard winter (good PMIs from Germany and the Eurozone this week), or the Ukraine conflict in some way may de-escalate (Patriot missile deployment a double-edged sword) and China find its way somewhat scarily out of Covid lockdown (the economy gearing up but infections spiraling)…..so maybe some positive catalysts emerge too. Our best wishes for the New Year to all our readers, whatever it brings.
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