Powell’s hopelessly hawkish message, and calibrating a market overshoot

Investors and academics often debate the topic of central bank credibility, and how that quality allows a few words and some economic projections to move all markets. But, over short-term (intra-month or intra-quarter) horizons, few things undermine central bank credibility more than economic data moving counter to the Fed’s baseline. It's the recent data flow around realized inflation that has overwhelmed Chair Powell’s net hawkish press conference yesterday, in turn driving market reactions typical of a Fed that could be easing in H2 due disinflation without a recession. Thus, every market but the still-expensive USD (chart 1) is rallying, with the highest-risk markets (megatrend ETFs within Equities and Crypto) outperforming and Growth stocks gaining on Value.

Chart 1: Even as it drops, the USD index remains expensive to rate differentials as a risk premium for recession. DXY versus US minus rest-of-world 10Y rate differentials (using DXY weights). Source: Federal Reserve, YCharts.

This article develops three points:

(1) that yesterday’s press conference showed unusually heavy emphasis on disinflation references, but within an overall hawkish message about 2023 monetary policy;

(2) that the broader labor market context still seems problematic for the soft-landing view; and that

(3) simple valuation models can assist in timing the exit from this H1 last hurrah, assuming markets succumb to restrictive policy in H2.?

1. How dovish or hawkish was Powell

By some simple measures, Powell's press conference was unusually dovish. He used the word “disinflation” 16 times to describe recent price developments, a word that hadn’t appeared in any of the previous three pressers. But on balance, he referenced inflation much more than disinflation. That word popped up about 100 times in yesterday’s Q&A, so the same frequency as in December but slightly more than in November ?and September (70 times in those presentations).

Beyond the mechanical word count, his overall tone struck me as hawkish, with all the standard references to “an extremely tight labor market”, “more work to do”, the need for “ongoing tightening”, the need for a “restrictive stance for some time”, and the requirement to see “substantially more evidence” of disinflation before easing. That message used to sink Bonds and Equities in summer/fall 2022, when inflation was generally rising and surprising to the upside. But all inflation and wage measures have been peaking since late 2022, and most surprises have been to the downside (two of past three CPI reports, last average hourly earnings and this week’s ECI).

2. Distinguishing between soft and hard landing, before the landing occurs

Those who invest based on momentum, whether of asset prices or of macro data, have good reasons to fade Powell’s hawkish message and thus extend their move out of Cash and into Bonds and Equities that began in November (chart 2). But for me, the causal path to sustained disinflation and H2 easing matters. I still don’t see that route opening as soon as the US money market does, given the labor market’s tightness on almost every measure (unemployment rate, vacancies, jobless claims, job creation, participation rate).

Chart 2: Individual investors have been reducing their Cash overweight since November, but they own too few Bonds for either a soft or hard landing scenario. Percent allocation to Cash, Bonds and Equities in monthly AAII survey. Source: American Institute of Individual Investors.

Others see the labor market as less critical to the soft versus hard landing debate, because they think that recessions are very unlikely without household/corporate leverage imbalances that become stressed by restrictive monetary policy. I agree that excess leverage, measured by the pace of debt accumulation during the easy-money years, has been a reliable leading indicator of future recessions once the Fed starts tightening. (Examples include the 2001 and 2007-09 recessions.) But I disagree that excess leverage is a required condition for job losses, recession and material market drawdown. Another set of cases should focus on inflation that is well above target even as it slows, which in turn motivates the central bank to stay tighter for longer and prolongs an earnings recession that eventually becomes a GDP recession. My baseline is that 2023-24 will deliver that outcome, but not until H2 given that the profits recession is only now starting. The article Yes to disinflation, Yes to profits recession, but Not Yet to GDP recession from Jan 13 discusses the profits-to-jobs-to-recession process in more detail.

3. Timing the exit from the last hurrah ?

If I am correct that disinflation is only partial, that the Fed doesn’t ease this year but that the profits-to-job-loss channel will require at least another quarter to bite, then I suspect Equity markets will overshoot and Credit spreads will undershoot what is justified by the economy’s performance. I use the over/undershoot terms to indicate a judgement that the US economy will deliver nothing better than it is delivering now (due to tight Fed policy), and that asset prices have been working off oversold conditions rather than becoming wildly rich to fundamentals.

Chart 3 illustrates why I choose this characterization. The red line plots the S&P500’s actual year-on-year returns, and the blue line plots predicted returns based on a model that relates stock performance to business cycle momentum (PMIs will Equities). A red line above the blue indicates an overshoot, or markets delivering stronger returns than would be justified by growth momentum. Such overextensions are common during Fed pauses, like those that preceded 2001 and 2007 recessions. By this measure, markets entered 2023 with a partial risk premium for recession, which has since closed. But Equities have not overshot. And as chart 1 showed earlier, a defensive asset like the trade-weighted dollar is still expensive, implying that non-USD currencies do not yet exhibit exuberance about a soft landing. When the USD’s valuation gap to interest rate differentials fully closes, I’ll probably conclude (all else equal) that markets are overly complacent about H2 recession risks.

To be clear, I still do not believe that Equities offer good risk-reward over the next 3 months, except in regions where growth might surprise to the upside in H1 for idiosyncratic reasons (collapsing gas prices in Europe, reopening in China). My preference has been, and remains, for almost all parts of DM and EM Fixed Income (ex High Yield), for non-USD currencies and for Gold rather than Oil. But for those wondering how to time their exit from a last hurrah, models like those in charts 1 and 3 are on my dashboard.

Chart 3: Since equity markets entered 2022 undershooting the economy’s actual performance, it is normal that they rebound now that the global economy is outperforming expectations. Predicted versus actual S&P500 returns year-on-year. Predicted returns calculated based on historical relationship between equity market returns and US ISM manufacturing index, based on monthly regression since 1999. Actual > (<) predicted indicates market overshoot (undershoot) of fair value. Source: YCharts.

Links to recent articles on global macro strategy

How Fed policy erases any distinction between cyclical and secular investing (Jan 25, 2023)

Why today's Bank of Japan decision isn't sticking to USD/JPY (Jan 18, 2023)

Yes to disinflation, Yes to profits recession, but Not Yet to GDP recession (Jan 13, 2023)

Market implications of the weakest US Speaker of the House in a century (Jan 8, 2023)

?What’s concerning about all US labor market data besides today's wage number (Jan 6, 2023)

What the last 100 years has to do with the next 12 months: Risk premia, mean reversion and 2023 return forecasts (Jan 3, 2023)

Late-2022 volatility compression, yesterday’s Fed realism and 2023’s labor market reckoning (Dec 15, 2022)

The Fed’s next moves are obvious, but 2023 remains a duration play (Dec 5, 2022)

China's COVID protests and the super-short Commodities supercycle (Nov 28, 2022)

Further evidence that 10Y bond yields have peaked, and what that path means for other markets (Nov 11, 2022)

What to do with the UK’s cheap markets (Oct 18, 2022)

Bonds are worth owning, even after yesterday’s strong US?CPI report (Oct 14, 2022)

Can?Emerging Markets ever be more than a tactical asset class? (Oct 10, 2022)

What to do with the second-strongest US dollar?ever (Sep 30, 2022)