The Investment Implications of Jackson Hole

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Whatever else anyone may say about Jay Powell’s much-awaited speech in Jackson Hole, it had two distinct virtues.?It was clear and it was brief, running to just 1,300 well-chosen words.

In the same spirit, and despite a sharp 1,008 point slide in the Dow Jones Industrial Average on Friday, it is important to be succinct in discussing both where the economy is and potential Fed policy going forward.?

First, despite the big stock market selloff, which gathered strength over the course of Friday, the speech didn’t have a significant impact on bond market perceptions of the Fed’s likely rate path.?

By the close of business on Thursday, the fed funds futures market was pricing in a 64% chance of a 75 basis point rate hike at the September 21st FOMC meeting. 24 hours later, that probability had risen to 66%.?The market is still expecting a rate of between 3.50% and 3.75% by the end of the year, one more rate hike to a range of 3.75%-4.00%?in early 2023 and two rate cuts later in 2023, cutting the rate to a range of 3.25% to 3.50% by the end of 2023 (although the futures market was pricing slightly less confidence in two rate cuts in late 2023 following Powell’s tough language).

Second, on the labor market, high frequency data suggest a solid jobs report this Friday – between +300,000 and +400,000 on payrolls, no change on the unemployment rate and wage growth of roughly 0.4%.?This could tilt the betting further in favor of 75 basis points. In addition, the JOLTs report on Tuesday could show a surprise rise in job openings which could also increase betting on a 75 basis point move.

Third, on inflation, the August CPI report, due out on September 13th, should be mild with a possible 0.1% month-over-month decline in headline consumer prices.?This could reduce the market odds on aggressive Fed action, although we could still go into the September 21st meeting with the market betting on 75 basis points in tightening.

Fourth, on the Fed’s intentions, Chairman Powell’s speech, like other communications from Fed officials in recent months, suggests that they feel some remorse for letting inflation get out of hand.?To be honest, they shouldn’t feel so guilty – the inflation surge is almost entirely due to the pandemic, the invasion of Ukraine and excessive fiscal stimulus by both political parties in recent years.?Be that as it may, the Fed appears determined to sound and act tough on inflation.??

Because of this, the easiest path for the Fed could be to maintain some doubt about whether they might raise rates by 50 or 75 basis points in September, then boost rates by 75 basis points on September 21st, thereby bolstering their hawkish credentials, and at the same time, in their statement and press conference, note that there is better news on inflation and signal that a smaller move was likely in November (+50 basis points).?They could follow this with a 25 basis point move in December.?This would take us to 3.75% to 4.00% by the end of this year from our current 2.25%-2.50% range.

The Fed could then stop hiking rates and hope that the economy will just avoid recession allowing them to maintain this 3.75% to 4.00% range and their current quantitative tightening program, which jumps to a monthly roll-off of up to $60 billion in Treasuries and $35 billion in mortgage-backed securities in September.

Finally, while it is likely that inflation will continue a gradual decline, it is a very close call on recession, with the economy potentially logging a positive real GDP growth number for Q3 and a negative number for Q4 and really wobbling on the edge of recession over the next year until short-term economic drags have faded.?One more shock and we would be in recession.

For investors, all of this suggests the potential for volatility in the short run.?However, it is also important to think about the economic environment over the next few years.?This will be an environment of fading fiscal stimulus hurting consumption, higher mortgage rates clobbering housing, slow profit growth inhibiting investment and a high dollar and overseas weakness hurting exports. ?

This will very likely mean slow economic growth and sliding inflation and, when the public becomes more fearful of recession than inflation, the Fed will likely slowly return to the more accommodative policy which it maintained in the decade following the Great Financial Crisis.?This should provide a positive backdrop for both stocks and bonds. However, any surge in volatility between now and then could lead to an even greater investor focus on defensive positioning and valuations which could favor long-duration bonds, value stocks and income-generating alternatives over more aggressive investments.?

For more of my insights, listen to my?Insights Now podcast ?for a breakdown on big ideas, future trends and their investment implications.

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