Multi Asset: Kapow!

On the Mark – Multi Asset Strategy - September 2022

Kapow!

• A misguided Fed

• Recession ahead

• More stock market falls to come

The Federal Reserve (Fed) has a dual mandate to foster economic conditions that achieve both stable prices and maximum sustainable employment.

The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for Personal Consumption Expenditure (PCE) is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee has also explicitly noted that the inflation target is symmetric and stated that it “would be concerned if inflation were running persistently above or below this objective”

They do not specify an explicit goal for employment but information about the FOMC estimates of the longer run normal rate of unemployment consistent with the employment mandate can be found in the Summary of Economic Projections, which the median participant most recently estimated to be 4.1 percent.

Figure 1.  The Dual Mandate

Source: The Federal Reserve Bank of Chicago

However, the Fed as proponents of the Phillips curve will know that these two policies create an uneasy tension. Whilst the Fed has raised interest rates and inflation has come off the top it is still running at 4.56% as shown in the chart below. They will have to do more.

Figure 2. US Core PCE

Source: Bloomberg 

Indeed, at the recent Jackson Hole meeting Federal Reserve Chairman Jerome Powell delivered a stern commitment to halting inflation, warning that he expects the central bank to continue raising interest rates in a way that will cause “some pain” to the U.S. economy.

So, what might that pain look like?

Handily a recent piece Mauldin shows a result modelled by the economics team at RSM, using both the Phillips Curve plus a proxy variable to account for supply chain deficiencies. The following chart shows the result.

Figure 3.  Unemployment rate projections based on PCE price index

Source: BLS RSM US

Using the Fed’s preferred PCE inflation gauge, RSM estimates unemployment (currently 3.5%) must almost double to 6.7% in order to achieve 2% inflation. Changing the target to 3% inflation would require “only” 4.6% unemployment. That is a lot of pain much of which may be ill judged.

Powell noted that the Fed’s failure to act forcefully in the 1970s caused a perpetuation of high inflation expectations that led to the draconian rate hikes of the early 1980s. In that case, then-Fed Chairman Paul Volcker pulled the economy into recession to tame inflation. While stating repeatedly that he doesn’t think recession is an inevitable outcome for the U.S. economy, Powell noted that managing expectations is critical if the Fed is going to avoid a Volcker-like outcome.

However, it is evident that markets are already indicating a recession is more than likely as per the indicators we mentioned in our piece in March 2022 – updated below.

Firstly the 5-year – 10-year US Treasury curve which is a harbinger of recession and has generally stayed inverted since early June.

Figure 4– US Treasury curve 5’s 10’s

Source Bloomberg

Secondly the 2-year- 10-year US Treasury curve which has stayed inverted since early July.

Figure 5. US Treasury curve 2’s 10’s

Source: Bloomberg

In our opinion the Fed are misjudging the situation, are not considering the complexities and oddities of this cycle created by Covid, the war in Ukraine and the resultant energy crisis. They are steering the ship onto the rocks of a recession and with-it stock markets will go lower as earnings are pressured downwards. This from Graham Secker at Morgan Stanley on the European earnings outlook against the backdrop of a spiralling energy crisis and scorching inflation “Our margin lead indicator is pointing toward the biggest decline in margins since the global financial crisis.”. Equally Morgan Stanley show that US earnings have a long way to fall if their leading indicator is to be believed as illustrated in the chart below.

Figure 6. Morgan Stanley Leading Earnings Indicator and actual S&P500 LTM EPS growth

Source: FactSet, Bloomberg, Morgan Stanley Research, https://www.zerohedge.com/markets/mike-wilson-sees-stocks-tumbling-3400-3-months-slashes-sp-eps-forecasts-fire-ice-shifts.

Policy error looms ever larger in our minds and we repeat that we are very mindful of Nomura’s Charlie McElligott’s point that the real contraction signal is not actually the curve inversion (albeit it is an essential part of the sequence) but instead the signal is when we get the steepening which tells you the market is “smelling the recession” – so keep a very tight eye on the US yield curve.

Our expectation for what the S&P may do is neatly illustrated by Ned Davis Research in the chart below. Unfortunately, it does not make pleasant viewing, but its better than Grantham’s recent warnings https://www.bloomberg.com/news/articles/2022-08-31/famed-investor-jeremy-grantham-warns-of-super-bubble-in-stocks-as-rally-falters?sref=aGyd2RGa

Figure 7. S&P 500 index 1973 vs 2022

Source: Ned Davis Research 

Mark Harris
Fund Manager, Multi Asset