This week investors tried to read the tea leaves of policies in China, and wondered if the U.S. economy may have a soft landing after all. In China, equity markets rallied after a pro-growth statement from the Politburo. Although short on details, it at least addressed investors’ worries and promised to make some changes. It also came amid bearish sentiment and very underweight positioning. Meanwhile, economic numbers in the U.S. are slowing in just the right way, while inflation pressures have eased in a meaningful manner. These have led the market to decide that we have seen the last hike in this cycle. Nothing Fed Chair Powell said at the press conference changed this view. Against this backdrop, U.S. equity markets continued to grind higher as the earning season marched on. But of course, the week does not end until we hear from the European Central Bank and Bank of Japan. In particular, European PMIs surprised on the downside this week, which points to risks of a more complicated fight with inflation. Nevertheless, hopes are rising that policymakers could manage policy just right.
Consensus is expecting that this week’s 25bps hike is the last of this cycle. In this week’s note we examine the data that could influence the Fed’s path from here, and assess the investment implications as risk sentiment continues to shift towards a “soft landing” scenario.
Strategy Question: Is this the last hike?
A year-and-a-half and 525bps later, the end of the Fed hiking cycle appears to be imminent. Markets are expecting the Fed to stay on hold until around spring of next year. One can be forgiven for feeling a sense of deja-vu here. Admittedly the uncertainty is high, not least because the economic data are still pointing to a strong labor market and above target inflation. Thus, a ‘pause’ is not a foregone conclusion. At the same time, economic data are lagging indicators, and even they are slowing. That means the optimal policy path increasingly points to a more “risk-management” based approach for the Fed, after such a rapid hiking cycle. This is not an easy decision to make, or to communicate. That further increases the risk of volatility for the rest of 2023, even as we see an increasingly clearer investment picture ahead.
The pros and cons of a ‘pause’
First, let’s examine the evidence. Drawing upon historical experience, we examined a number of macro indicators after the last Fed hike in the past eight hiking cycles, and calculated the average values of those indicators two months after the last Fed hike to come up with a rough criteria for a Fed pause. The super-core CPI criteria was defined by Fed Chair Powell, while the Atlanta Fed median wage tracker was based on a regression versus the Employment Cost Index (ECI). While it may feel like an inalienable principle in economics at this point, the Fed’s 2% inflation target was only formally declared in 2012, which was not a long time ago in the context of business cycles. As such, we have not included this measure in this exercise.
While the data can be broadly grouped under the two distinct categories of labor market and inflation, depending on the individual measure, they are either very close or still some distance away from a Fed pause. This is perhaps a testament to how unique this cycle has been in terms of the pandemic’s varying impact on various sectors of the economy. Payrolls and a “super-core” measure of inflation are within range of the Fed pause criteria, while claims and wage growth suggest a labor market that is still too tight for the Fed’s comfort.
But the trajectory of inflation has been encouraging, and growth is still slowing. So with a more forward-looking mindset, a pause might well be the most sensible thing to do. Now let’s examine what forward-looking investors may see.
Inflation has moderated substantially since its peak a year ago. We are now in a different macro and market environment than twelve months ago, when inflation was accelerating and threatening to spiral out of control. Today, inflation is much closer to 2% than 10%.
At the headline level, energy prices have fallen significantly since last year and could remain relatively steady amid supply contributions from U.S. production. Food prices are seeing risk pick up related to supply disruptions from an escalation of the conflict in Ukraine (which has made headlines in recent weeks), though the magnitude and impact should be relatively muted compared to the early days of the invasion. At the core level, goods prices are likely to be steady or decline with easing supply chain issues and a continued consumer focus on services spending over goods. Leading indicators of used vehicle prices are also pointing to a sharper decline in the coming months.
The last remaining driver of inflation is core services. Shelter has a large weight in this measure and has contributed to the continued resilience of core inflation. Real-time measures of market rents suggest shelter inflation could continue to slow going into the end of the year, as official data has a significant lag. Stripping out shelter, the remaining portion of core services is dubbed “supercore”, which Fed Chair Powell has focused on in recent months. A smoothed version of this measure, which is closely tied to the labor market, has cooled to 3%, in-line with the criteria for a Fed pause as we outlined above.
As such, while core inflation appears to be “stuck” in the high-4% range, underlying and forward-looking data suggest further declines in the coming months, especially as economic momentum continues to slow under pressure from higher rates.
Meanwhile, economic momentum appears to be slowing. On the consumer, recent retail sales numbers continue to suggest they are holding up well, largely supported by a solid labor market and strong wage growth. However, estimates of excess savings suggest that they have largely been exhausted after the massive pandemic expansion, and most of it is sitting with higher income earners who have a lower propensity to spend. If the labor market continues to rebalance slowly, spending will also likely slow. Credit card and auto delinquencies are picking up, although from very low levels. Student loan repayments are also restarting this summer, which will likely be an additional headwind.
Even the labor market, one of the most lagged indicators, is softening. Markets thought it would slow faster, or by a larger magnitude. The pandemic-era stimulus and the post-pandemic structural shifts have been difficult to account for. The widely followed indicator of initial unemployment claims have bounced around in recent weeks, caught between various technical factors such as seasonal adjustments and state-specific issues, making it difficult to draw signals from. However, broader labor market fundamentals are pointing in an encouraging direction. Job gains have continued to cool gradually, with monthly nonfarm payroll gains falling close to 200K and coming within sight of the criteria for a Fed pause.
Labor supply has also continued to return, with the labor force participation rate for those aged 25-54 breaking the pre-pandemic level in June, while legal immigration has also rebounded to pre-pandemic levels. Overall, these factors are likely to continue easing an overly-tight labor market and lead to a gradual moderation of wage growth, which is strongly related to “supercore” inflation.
Putting it all together
Over the last two years the Fed has been managing the trade-off between growth/employment and inflation by slowing growth just enough to bring inflation down to target. It continues to face this challenge, but after such a rapid hiking cycle, and after signs of cooling inflation and growth, the trade-off has gotten a little bit easier. This could allow the Fed to take a pause and gather more evidence on the trajectory of the economy. The economic evidence will likely also continue to (largely) support a pause in the coming months, which means July could well be the last hike.
Investing during a Fed pause is very different than during a seemingly endless Fed hiking cycle. Yields have likely peaked, which means the time to lock in yields is now. Potentially declining cash rates present reinvestment risk, and locking in attractive yields for longer would still be one of the keys for investors to achieve their long-term goals when it comes to income and diversification in portfolios.
As we put the rapid hiking cycle behind us, the case for rebuilding equity exposure grows, even if volatility will likely remain. As investors look towards the end of the rate hike cycle, we believe that the highly-concentrated rally in equities this year can broaden. It may lead to the outperformance of an equal-weighted index, as the rest of the market beyond the top six to seven performers play catch up (which they have started doing in the past few weeks). As such, relative value trades and structures capturing these market shifts appear attractive from a risk-reward perspective.
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