Goldilocks and the One Bear (and One Bull)

“Meltdown expected, the wheat is growing thin” ? ????????? The Clash, London Calling

Written by Neil Staines, 2nd August 2024.

Last week, we discussed US exceptionalism, equity sentiment and the prevailing macro tailwinds. The Q2 GDP first release in the US was stronger than expected - coming in at around 2.8% q/q annualised. The bulk of the growth came from real private final domestic demand, suggesting that the consumer remains resilient despite signs of moderation in broader metrics and forward-looking surveys and earnings reports. There were also bigger than expected contributions from inventories and government expenditure, which we argued would lead to a less convincing breakdown for the quarter if, as was the case in Q1, consumption ends up being revised significantly lower. Furthermore, we reiterated our long-held view that the Fed's sensitivity to weaker growth (higher unemployment) is asymmetric, given that policy is clearly in restrictive territory and inflation has moderated significantly. Equity market volatility might also affect the Fed’s reaction function.??

We also discussed the importance of disinflation and the rate-easing cycle on sentiment towards corporate valuations. The Magnificent 7 stocks, for example, are demonstrably cash-generative and have strong (monopolistic) pricing power - thus, a backdrop of rising inflation and high rates is a net positive. Recent de-grossing or rebalancing across countries and sectors has therefore made sense against a backdrop of falling inflation and rising rate cut expectations. However, We argued that If we take a step back from the near-term volatility and position adjustments that were dominant last week, we would argue that little has changed from a macroeconomic perspective.?

This week, global central banks were front and centre of the policy debate.

Bank of Japan - Too hot?

The Bank of Japan raised rates to 0.25% from 0-0.10% and pledged to significantly curtail their asset purchases over coming quarters. Governor Ueda stated that it was “appropriate to raise rates under the current environment”, with positive consumption against a backdrop of rising wages and rising prices. The Commitment of the BoJ to raising rates - coincident with a clearer narrative around potential US rate cuts - has led to a clearer narrowing of real rate differentials between the US and Japan, which has had a significant impact on the JPY this week. This is a theme that we continue to play out from what we consider to be a still significantly undervalued JPY.

Bank of England - Too cold?

The mortgage bearers of the UK breathed a communal sigh of relief this week as the Bank of England cut rates 25bps. We highlighted last week that there was a strong likelihood that Governor Bailey would carry the centre ground (Lombardelli and Breeden) with him if he turned his ‘finely balanced’ view into a rate cut. Bailey, it appears, was suitably convinced by the implications of moderating demand on the path of inflation.

Rather than comment on the future path of policy in the UK, Bailey outlined the framework for policy - the recommended framework from the Bernanke review into forecasting and processes in times of significant uncertainty - into a probabilistic interpretation of three scenarios: (i) that inflation is in large part self-correcting and a function of a passing global shock (no persistence), (ii) inflation requires a weakening of demand to bring prices to target, (iii) there is a permanent or structural change in the labour market or price formation that maintains inflation persistence. Bailey emphasised that it is the evaluation of the economy under this framework at each policy meeting that will determine the Bank’s policy response and thus the path of interest rates.?

For us the underlying momentum of the UK economy is weaker than the data suggests, and thus, we would hold a higher probabilistic weighting to scenario (ii) (as well as a broader belief that (i) is also true). Underlying weakness in the UK growth momentum as the year progresses, especially if we see further tax rises (as the recent statement from the Chancellor suggests), do not preclude a path of rate cuts of higher increment by year-end!??

FOMC - Just right?

Although the Fed left rates unchanged (as widely expected), the FOMC was likely still the most material of the three DM central bank meetings this week. There were some very minor changes to the statement, but for us the changes allude to a material shift in focus and emphasis from the Fed. On the labour market, what was previously referred to as “remained strong”, is now “moderated” (adding the specific reference that the unemployment rate has moved up). On Inflation, the new characterisation is that it remains only “somewhat” elevated, and the amount of progress made on inflation has been upgraded to “some”, from “modest”. Most importantly, perhaps the sentence “highly attentive to inflation risks” has become “attentive to risks on both sides of the mandate”.?

Ultimately, there was a clear rebalancing of the views of the Fed. We have argued for many weeks now that the Fed reaction function to higher unemployment has become notably more acute. The July FOMC clearly validated this view. Furthermore, Powell stated during the press conference that it is clear, through the rebalancing of the jobs market that “policy is restrictive” (a moot point among many commentators and even at the Fed until recently). This combination of a more balanced emphasis on the risks to the policy activism from the Fed against an affirmation of the restrictiveness of the current policy setting is, for us, a dovish pivot.

There was a great question in the FOMC Q&A this week, where the WSJ columnist asked whether the Fed should consider cutting rates ahead of the unemployment reaching equilibrium in the same way it has expressed a preference to cut rates well in advance of reaching its inflation equilibrium. This is an interesting point given the recentering of the balance of risks between inflation and growth and the clearly restrictive current policy setting.

The Long & Short of it...

This week has seen a clear pickup in baseline volatility as markets assess the implications of lower global (ex-Japan) rates. While we remain of the view that the US economy is slowing, we are not of the view that recession is imminent. This has important connotations for equity markets. If growth slows but remains positive and rates are cut as inflation normalises, policy should provide a tailwind for equities. Not quite Goldilocks, perhaps. But rosier than some current participants fear. Indeed, to Paraphrase the Clash More ‘wheat growing thin, than meltdown expected’.

What is happening next week?

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