Recession vs Inflation: Why the Fed is making a monster to fight a monster
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He who fights monsters should look to it that he himself does not become a monster. And when you gaze long into an abyss the abyss also gazes into you.
— Friedrich Nietzsche (1886) Aphorism 146 Beyond Good and Evil
Global equity markets took on further water this week following the US Federal Reserve’s latest lifting of its target interest rate by 75 basis points (bps) to a range of circa 3.00%-3.25%.
The Fed had already hoisted short-term rates by 225 bps and has clearly flagged there’s more in the post as new Fed projections show its policy rate rising to 4.40% by Christmas, before (theoretically) topping out at 4.60% in 2023.
The US central bank plans to fight the war on inflation on two fronts, as it continues to shrink its balance sheet.
The Fed envisages inflation slowly returning to the Fed’s 2% target in 2025, at the small price of creating a global recession – now forecasting annual US economic growth grinding down to end the year at an abysmal 0.2%, and (ideally rising) to 1.2% in 2023.
And right at the pointy end of the relentless ascent of interest rates, where inflation meet recession, are the stock markets everywhere which’ve been tormented and belittled and may’ve had a bit of an inflated sense of self anyway.
Valuations have been intensely compressed but with so much money still waiting in the wings, most prospects have apparently not yet been humiliated enough to lure in the bargain hunters.
The risk that earnings estimates have lower to go as the data pulse slows, (especially in Europe and China) remains very real.
And while this has all the necessary ingredients to make life harder for fans of equities, Peter McGuire, CEO at XM says it’s also a great time to “not lose sight of the big picture”.
Because the commonality here is that every crisis passes.
Or as Jean-Paul Sartre liked to say:
“Every existing thing is born without reason, prolongs itself out of weakness, and dies by chance.”
– Drunk, friendless French misongynist and existentialist
Thank you, JP.
The Fed is trying bloody hard to get out in front of inflation and if investors weren’t certain of the FOMC’s commitment, then they should be now.
Sifting through the ashes of this week’s third 75 basis point rate hike, Morgan Stanley’s chief fixed income strategist Jim Caron says the Fed’s latest will weigh on asset valuations and tighten financial conditions.
Recorded overnight, here’s a few cherries from Morgan Stanley’s latest poddy:
- The 75 basis point (bps) rate hike came as expected, but one surprise was the 100 bps markup in end-of-year policy rates to 4.4% from 3.4%.
- The next surprise was the increase in the Fed’s forecast of their terminal policy rate to 4.5% – 4.75% from 3.8%.
- The path of rate hikes corresponds to a 75 bps hike at the November 2022 meeting, a 50 bps hike in December 2022, and a 25 bps hike in January 2023.
- Despite this aggressive pace of tightening, the Fed expects the labor market to remain strong with an unemployment rate rising only to 4.4%, while inflation simultaneously falls toward target levels of 2%-2.5%.
- While the front-loading of rate hikes may address inflation risks in the near term, it also increases the risks of recession in the longer term. This will weigh on asset valuations and tighten financial conditions.
For more than a decade after the (GFC) financial crisis, central banks and equity markets were as thick as thieves.
“It was a period of very low inflation, so every time the economy was in trouble, investors could count on central banks riding to the rescue by lowering interest rates or doing quantitative easing,” McGuire told Stockhead.
“This recipe is rocket fuel for stocks.”
“In a regime of low or negative interest rates, returns on bonds are miniscule, which naturally pushes investors towards riskier assets.
“With money managers raising their exposure to stocks and companies enjoying easier access to capital, valuations usually expand and markets thrive.”
An overload of public spending during the pandemic coupled with supply chain problems and the Ukraine war came together to generate the greatest inflation shock in four decades, McGuire says.
Central banks – spearheaded by The Fed – made the the policy of least regret decision to start raising rates hard and fast.
“Policymakers hope that higher rates will lead to an economic slowdown, initially in sectors such as housing that are more sensitive to higher borrowing costs and ultimately in the broader economy. Once unemployment begins to rise, that will hopefully reduce demand enough to cool inflation.”
In short – just as Friedrich Nietzsche warned us not to – the Fed’s plan is to engineer a recession in order to fight inflation.
Over time, Pete McGuire says, rising interest rates mean lower valuations for riskier assets as traders dial back chancing their hand in favour of safer plays.
“This is precisely what happened this time – most of the selloff in stock markets boiled down to a compression in valuation multiples.”
Since the beginning of the year, the S&P 500 index has lost 21% of its value, while its valuation from a price-to-earnings perspective is down around 25%.
“And yet, massive correction though, it was, the S&P 500 still isn’t cheap from a historical perspective,” he adds.
The price-to-earnings (P/E) multiple denotes the dollar amount someone would need to invest to receive back one dollar in annual earnings.
As such, Pete says, the lower this number is, the ‘cheaper’ the market is considered.
“The S&P is still trading at a forward multiple of 16.8x, while most of the selloffs over the last decade – for instance in 2020, 2018, 2016, and 2015 – ended with a multiple closer to 14x or 15x earnings.
“In fact, that may be too optimistic since the last decade was characterised by ultra-low interest rates, and therefore elevated valuation multiples. With rates much higher now and the Fed’s quantitative tightening process doubling in speed this month, this bear market might conclude with an even lower valuation multiple, leaving ample scope for further downside… Even more so if earnings estimates are revised lower.”
“So, the Fed is actively trying to weaken the US economy and the bond market is screaming it will get its wish, with the yield curve inversion deepening further.”
This week the rate-sensitive 2-years are testing 4%.
That puts them above 15-year highs, while the 10-years are above 3.5% for the first time since 2011.
“That’s bond traders betting on the economy going downhill, and it has preceded recessions with terrifying accuracy,” Pete warns.
And step back for second as well. Take a look at the global shape of money flows. Companies in the S&P 500 receive some 40% of their revenue from overseas, increasing to almost 60% in the tech sector.
Those revenues will come under pressure from two sources – a stronger US dollar and the twin crises tormenting Europe and China.
Winter in Europe could be harsh considering the dramatic spike in energy prices. Authorities have rolled out several measures to spread the burden, but the consumer will still take a heavy hit. The situation in China is even worse, with the property sector melting down and strict Covid lockdowns in major cities – a combination that has brought the economy to its knees.
So don’t bother.
“He suffers more than necessary, who suffers before it is necessary.”
― Seneca (long dead Roman)
“All told, there’s likely some more downside left for equities, especially in case a recession hits. There is a long lag between raising interest rates and the time it impacts economic activity, so the real effects of the forceful tightening today might only show up next year.”
Business surveys and other leading economic indicators already paint a grim picture of what comes next and the charts concur, with the S&P 500 trading below a downtrend line and its key moving averages. If it does break to new lows, a fierce battle could take place around 3,500, which is the 50% retracement of the rally from covid lows to record highs.
Beyond that, the focus would turn towards the 3,200 region, some 15% lower from current levels. This is where the risk-to-reward profile would become much more favorable, as that region would be consistent with a valuation of around 14x forward earnings.
“Even if there is a recession, it is likely to be shallow since it will be caused by the Fed itself, not some external shock. Once the economy is in real trouble, the Fed can turn the ship around, assuming the inflation problem is cured by then.
“Don’t miss the forest for the trees – every crisis passes and markets move higher over the years. This storm might simply offer patient investors better entry points,” McGuire says.
این نیز بگذرد, “This too shall pass“
– Cool Persian aphorism
According to Morgan Stanley’s chief economist Ellen Zentner another 75 bps move in November is now likely – up 25 points from the previous forecast:
“The US central bank will stay higher for longer than the market expects…
Though a fourth hike in November is not guaranteed, Chair Powell’s tone today and our data forecasts make that our base case.”
JP Morgan’s chief economist Michael Feroli in the note Bring the pain reckons the Fed will hike 50 bps in November, but has raised JPM’s December view to another 50 bps, lifting its terminal forecast up 25 bps to 4.5%.
“The response of the real economy to higher rates has been muted thus far, leading the Fed to pencil in a higher peak rate and longer hiking cycle. We think inflation persistence will keep the Fed at peak for most of next year, challenging the market’s assumption of an earlier start to cuts.
“The new forecasts are not only more hawkish but somewhat more realistic, as they now recognise at least some labor market weakness will be needed to get inflation down. Even so, it’s still close to an immaculate disinflation, as only a whiff of labor market weakness generates a very sizable (sic) decline in inflation.”
The views, information, or opinions expressed in the interview in this article are solely those of the writer and do not represent the views of Stockhead.
Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.