Privatus CIO Gazette (Thursday, November 3rd, 2022): Squaring The Circle - Slower For Longer

Good morning all,

Apologies in advance for a relatively long missive this time, but important information deserves more in-depth treatment, and TV-style soundbites would be counter-productive to mutual communication and understanding. Hence this is a "CIO Gazette" not "CIO Flash" - I'm nothing if not pedantic!

So the Fed is far from done,?but smaller hikes are on the way as soon as December. Jerome Powell warned overnight Asia time that the top end of the central bank's benchmark rate (the "terminal rate") will be higher than previously expected after the FOMC announced the fourth 75 bp increase in as many meetings.

US stocks?sank?and bonds dropped on Powell's hawkish comments in a session of wild gyrations. The S&P 500 fell 2.5% and the Nasdaq plunged 3.4% as megacap tech bore the brunt of the selloff. Treasuries yields erased all their losses and rose across the curve, with 10-years up 5 bps to 4.09%. The dollar also reversed course and advanced against every G-10 peer save the yen.

Where Are We Now?

The Fed faces a difficult conundrum. The primary focus, it is crystal clear, is Inflation. The other piece of the Fed's dual mandate, Unemployment, is relevant to the argument as well.

The situation we are faced with at the moment is one where stubbornly high inflation and a strong jobs market (with concomitantly low unemployment) combine to make the path ahead clear. Having mismanaged the rise of Inflation since late last year, the Federal Reserve now has no option but to focus on that as the primary priority, trying to kill the beast via a programme of aggressive rate hikes.

What makes the decision to persevere with the above path is the continued strength of the US labour market, which has been exceptionally resilient all year despite the inflationary environment and the past few rate hikes. This has kept unemployment low and consumer spending relatively resilient despite the most severe inflationary environment in 40 years.

And Your Detailed Thoughts, Vinod?

Amidst all the information overload, it helps to keep one's eye on?a few key data points?to clarify one's thinking -?CPI and PCE (Inflation), Non-Farm Payrolls (Labour market health), Consumer Spending and US GDP (general economy).?Consumption is 70% of the US economy, with consumer spending the bulk of that. Any trend in consumption is a leading indicator for economic health and inflation trends.

The rest of the data points swirling around essentially feed into the above. A few factoids among these to help frame the discussion:

• The last reading of?US Headline CPI?rose 0.4% in September month-on-month. Year-over-year inflation rose 8.2%, down from 8.3% in August, but above the 8.1% consensus estimate.?Core CPI?rose 0.6% month on month, substantially higher than the consensus expectation of 0.4%
• The?PCE deflator?(The Fed's preferred measure) rose 0.3%, month-on-month, matching the consensus. The core rose 0.5% MoM, also matching August’s monthly pace. Headline YoY PCE was stable at 6.2% versus consensus of 6.3%. Core PCE accelerated to 5.1% from 4.9%, but lower than the consensus of 5.2%
• Last month,?headline Nonfarm payrolls?increased by 263k in September (vs. 315k in August). The two-month net revision showed hiring was 11k higher over the previous two months than previously thought. Employment increased 204k (vs. 442k prior)
• The next reading of this key indicator will come out tomorrow. Meanwhile the?monthly ADP Institute data?(which regularly comes out a few days prior and is seen as a reasonably reliable, though not infallible, precursor) came out earlier this week. It clearly pointed to continued labour market strength. Private payrolls rose 239,000 last month after a revised 192,000 gain in September, versus a median forecast for 185,000
• As a further pointer to the Friday's key data, the?JOLTS Job Openings?data from Tuesday also pointed in the same direction. The number of job openings rose by 400k in September, versus expectations for a decline (-250k). The ratio of job vacancies to unemployed persons rose back to 1.86 after dropping to 1.71 in August, down from a peak of 1.99 in March, significantly higher than the 1.15 seen at the end of 2019, just before the pandemic began.
• Personal income?grew 0.4%, as per the last release?and Consumer spending?remains resilient. Last month's 0.6% rise in nominal consumer spending was stronger than consensus (0.4%). The level of inflation-adjusted spending is up 1.2% annualized from the full Q3 average. Spending in real terms increased by 0.3% in September. The figure suggests momentum held up ahead of the fourth quarter, following a 1.4% annualized gain in 3Q

Recent GDP revisions,?a?crucial but underappreciated?release from the Bureau of Economic Analysis, also likely influenced the Fed’s inflation projections overnight.

• The BEA raised their estimates of the real GDP level from 1Q 2017 to 2Q 2022, the latest quarter. The largest upward revisions were during the pandemic - the?GDP level has been running around 1% higher than believed?since 3Q 2020. That means the economy is more overheated than thought, and the Fed will have to engineer an even longer period of below-potential growth to close the output gap
• Inflation was worse this year than previously thought. All price gauges - the GDP deflator, core GDP deflator, and headline and core PCE deflators - were revised up across the board. Notably, in the second quarter the annualized quarterly change in the headline PCE deflator was revised up 0.2 percentage point to 7.3%, and the core PCE deflator was revised up 0.3 ppt to 4.7%. Translated to what this potentially means for the Fed - Bloomberg's model estimates that?75 basis points of extra hikes?are needed to eliminated the extra 0.3 ppt of inflation (right now, only another 25 bps in May is factored in)

So Now What?

• "Slower for longer" to borrow the JPM Economics team's phrase. The Fed has little option but to keep hiking until there is clear evidence of inflation coming off more convincingly
• A?recession next year is almost inevitable, as this delicate dance aiming for a "soft landing" will prove almost impossible to execute, and will prove more difficult (and recession more inevitable) the longer rates keep going up. The terminal rate priced into the Rate market has now edged up to 5.1% although interestingly, Chair Powell's guidance of raising for longer seems only partially to have been taken on board. The pre-FOMC date of March 2023 as the last hike point has only been pushed forward by 1 meeting, to May 2023

• Having said all of the above, it's?not all bad news. I happen to be in the camp that believes that a lot of what the Fed wants to see will start becoming evident sooner than perhaps is obvious right now. A few (relatively) positive signs:
• The October ISM survey added to the sense that?disinflationary trends are continuing in the goods sector. Input prices fell (46.6 vs 51.7 prior) and supplier delivery times quickened (46.8 vs. 52.4 prior). This ties in with other evidence that goods inflation is clearly dropping quickly

• The silver lining on?core inflation?is that evidence for last month's data indicated it?likely has peaked in September. Negative base effects will push it down in the months ahead. Of note, though, is that Shelter costs continued to grow at the same robust 0.7% pace in September as August. The year-over-year increase for rents or owners’ equivalent rent may not peak until 1H 2023, thus slowing the overall pace of decline

• The above-mentioned?revisions?from the BEA also?showed that?economic activity was weaker in 1H 2022 than many thought. The average of GDP and Gross Domestic Income (GDI)?now shows an annualized decline of 0.3%?(vs. 0.4% expansion in previous data), a second consecutive quarter of contraction. Hence, the inevitable recession referred to above may be more imminent than generally thought
• Why is this a positive?sign? In our current Alice-In-Looking-Glass world, it seems clear to me that a marked slowdown in economic activity would inevitably feed through into the jobs market, and wage growth, sooner than currently apparent from the data.
• Ergo -?a slowdown in consumer spending, and a consequent drop in services inflation?(which has been the primary driver of overall inflation readings so far),?seems not far away. Keep an eye on?the Savings Rate as a sign?that consumers are now dipping into their cash pile - this would indicate unsustainable consumption and an imminent slowdown.

OK, So What's?Finally?Your Point, Vinod?

• To cut to the chase, I believe that incorporating lag effects (especially of Shelter inflation and the Fed rate hikes themselves), financial conditions would have tightened to an acceptable level by Mar 2023
• Asset markets will continue to be challenged until then, and we expect continued volatility. However, Markets are forward-looking creatures and?we think that the bottom is in
• In?Equities?- we will bounce around here with headline index levels masking?divergent paths for Value versus Growth/ Cyclicals. There is clear evidence of a?shift in capital allocation to Value?(Consumer Staples, Energy, Health) and?away from Growth?(Tech, Biotech). This is?nothing less than a paradigm shift?compared to the last 5 years or more. Regime change is upon us
• Also, in?Fixed Income,?we have been saying for a several weeks now, that?high-quality Investment Grade issuers?offer value.?Preferably shorter maturities/ call dates, < 3 years, although hold-to-maturity retail investors need not concern themselves as much with the M-T-M risk
• Macro remains the favoured overall strategy to generate alpha,?as FX and Rates markets continue to provide a once-in-a-generation opportunity. Unfortunately, less accessible for retail - call us!

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Happy almost-Friday. Have a great weekend.