When Theodore Roosevelt encouraged policymakers to “speak softly and carry a big stick,” clearly, his target audience was not central bankers.
Speaking firmly is a key tool that monetary policymakers have in influencing markets and eventually economic data. Sometimes speaking firmly is to encourage markets to be more optimistic, such as Mario Draghi’s 2012 “whatever it takes” speech. Other times speaking firmly is to cool the heat in markets or the economy, such as Greenspan’s 1996 “irrational exuberance” speech, or this Friday’s “keep at it until the job is done” speech by Federal Reserve Chairman Jerome Powell at the Jackson Hole Symposium.
In this short speech, Powell outlined a plan to raise interest rates into restrictive territory and keep them there for “some time”, to be confident that the high inflation forces at play in today’s economy today are sufficiently under control.
On the surface, this seems like a simple reiteration of the Fed’s messaging in recent months; however, Friday’s speech was significant because its message was precisely counter to what markets started to price in since mid-June.
Taking the prospect of a near-term peak in elevated inflation and running with it, in mid-June, markets began to bet that the Fed would not only have to tighten less than its stated guidance in its Summary of Economic Projections, but that it would be quick to cut interest rates in 2023, all without dire projections for economic or earnings growth. A true having of one’s cake and eating it too.
This pricing of a more accommodative Fed and a more benign growth and inflation environment coincided with a drop in interest rates (both short and long term), a fall in the US dollar, and a vigorous rebound in equities, primarily those most sensitive to liquidity (such as high growth, high valuation, and speculative stocks).
Since mid-July, Fed speak has been pushing back against this market pricing of a quick “pivot” to rate cuts in early 2023. Eventually bond and currency markets caught on, with both yields and the USD resuming their ascent, reflecting the tighter Fed. However, equities continued to press higher in these hopes of stable growth and policy that wasn’t overly restrictive.
We warned against this “dangerous divergence” between equities, bonds, and currencies earlier in August. We pointed out that equity valuations, which had quickly become stretched for broad indices, were far too high given the current Fed policy and liquidity backdrop.
And last Friday, in a sharp, curt speech, Powell forced equities to wake up to this divergence.
He promised the Fed would “use our tools forcefully to bring demand and supply into better balance,” which would likely result in a “sustained period of below trend growth.” But, most importantly, he argued that “historical record cautions strongly against prematurely loosening policy” and that “central banks can and should take responsibility for delivering low and stable inflation.”
These statements are very important because they reveal how the Fed plans to respond to potentially weaker growth in the coming quarters.
In the last 12 years since the great financial crisis (GFC), the Fed was ready, willing, and able to step in to support markets and growth at the first sign of a wobble, made possible because inflation was benign and below their target. But today, the Fed is telling us that it is in no position to react quickly to softer growth because it must prioritize the fight against high inflation.
Further, this is clearly a Fed that is haunted by the ghost of Arthur Burns, chair of the Federal Reserve from 1970 to 1978. Burns oversaw the period from 1974 to 1975 where the Fed raised rates to fight inflation, then cut rates to fight weaker growth, then inflation roared back, resulting in a return to rate hikes. Many economists argue that this Stop-Go policy is what cemented inflation expectations in consumers’ minds, turned a cyclical inflationary episode (caused by supposedly exogenous factors like the OPEC oil embargo) into a secular one, and eventually necessitated Volker’s early 1980s strategy of raising rates and keeping them there for a much longer period of time in order to fully slay the inflation dragon (of course with the cost of causing deep recessions).
By pushing back against early rate cuts and taking responsibility for controlling inflation, the Fed is signaling that it will be hesitant to cut rates in the face of weaker growth and even moderating inflation, for fear of reigniting the elevated inflationary forces that it considers to be so destabilizing today.
And thus, the Fed is promising that it will “keep at it until the job is done.”
So what does this mean for markets and investors?
First, we expect equity volatility to pick back up after a subdued two months. We think equity valuations are too high given the Fed’s resolute path towards tighter liquidity. High valuations would not be as great of a headwind if we thought earnings estimates were low and depressed; however, we still observe S&P 500 EPS growth estimates of 11% for 2022 and another 8% for 2023 (Bloomberg, as of 8/26/22). This is a high bar to surprise to the upside.
Second, we think quality will return to leadership in the near term after lagging the past two months during this beta and junk rally. It is important to impress that we do not own quality to outperform in every market environment, but instead we own quality to have exposure to names that we can own through market cycles, unlocking the power of compounding growth.
Third, we think credit markets could begin to retrace their recent rallies as well, meaning spreads likely widen (bond prices fall) as credit markets price in both tighter policy from the Fed and a higher risk of a hard economic landing (a period of much weaker economic growth).
Fourth, from a balanced perspective, we do see a lower probability today that we retest the June lows or plunge to new lows thanks to the powerful momentum and breadth coming out of the June low. Typically, when momentum and breadth are as strong as we recently saw, forward equity returns are strong as well. There of course could be some kind of liquidity shock or greater shock to earnings that pulls markets lower, but outside of those shocks, we must acknowledge the improvement we have seen under the surface for this equity market. These measure of momentum and breadth are not perfect predictors of forward returns, but the probability of better outcomes is higher today after the power of the recent rally.
Fifth, we note the returning strength in commodity markets as an important watch item for inflation statistics and expectations. These commodity rallies are pure supply and demand related, as they are happening with a backdrop of a much stronger dollar. We maintain a strategic ~2% weight to commodities in our broad asset allocations, while also remaining overweight the energy sector in many of our equity portfolios as a relatively cheap hedge against another leg higher in energy prices.
Overall, we do not think we are out of the woods in this choppier equity market, mainly because earnings estimates remain robust, while the Fed is showing no sign that it will begin injecting liquidity into this market, a (most always) necessary condition for higher valuations.
The Fed does not see its job as done yet today, so until then, it will likely have to “speak firmly and carry a big hike.”
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