Market Thoughts: We've never seen a cycle like this before

• I struggle to point to a prior moment as proof statement for why policy rates shouldn’t be higher. They need to be. We’ve never seen anything quite like this cycle before.
• Monetary policy acts with a lag. First, we see a tightening in financial conditions. That’s followed by a slowdown in economic activity. Finally, we’ll see inflation durably move lower.
• Over the next few quarters, I expect global earnings expectations to be revised down by analysts. Companies have been able to pass along rising input costs so far. Those days are behind us.
• Investors haven’t capitulated on markets. Concern can creep into the market narrative if risk assets fully round trip the past few years. That will take time for investors to emotionally process.

It’s the destination that matters. The best I can say about inflation is that it remains stubbornly high. It’s going to take additional data to confirm we’re transitioning from peak inflation. The strategy for the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE) is to continue to front-load tightening. They’re moving assertively to slow and then stop hiking at some point next year.

Central banks will begin to rein in the size of rate hikes. Ultimately, it’s the destination not the pace of rate hikes that matters. For all the wishful thinking that a policy pivot is coming, Jay Powell reiterated after the November Fed policy meeting that peak policy rates are higher from here.

While central banks will continue to raise rates into next year, my sense is the BoE and ECB will be forced to pivot sooner than the Fed. A policy pivot isn’t a pause or slowing the pace of rate hikes, it’s a change in direction. We’re a long way away from that happening.

We’re likely to remain in a ‘stronger-for-longer’ dollar environment. That will weigh on the U.S. earnings outlook and while it’s constructive for European exporters, it’s too early to lean into Europe. We remain underweight European equity markets in multi-asset portfolios. We’re overweight the U.S. as we believe international equity markets have greater relative downside.

Like inflation, I hope we’ll soon see ‘peak’ dollar. If we get another marked move higher, it will weigh further on the global economy. It will keep inflation higher for longer (Figure 1). For emerging markets, it may be the catalyst that tips sentiment lower, adding to concern of rising default risk.

We’ve never seen anything quite like this. I struggle to point to a prior moment as proof statement for why policy rates shouldn’t be higher. They need to be. Especially in the U.S., where labor markets—not to mention personal consumption and individual balance sheets—remain well supported in the face of Fed tightening. We’ve never seen anything quite like this cycle before.

There is no prior game plan to point to and learn from. To a large degree, that is creating the unwavering uncertainty investors continue to feel. It has left market moves explosive and shifted investor activity to trend following and day trading. I believe that’s the market environment we’re going to be in for a bit longer, as wearying as that is to hear.

Both unemployment and policy rates will move higher. Operating margins will return to lower trend levels as earnings forecasts are taken down by analysts. I don’t believe it’s fully appreciated how protracted the transition to lower inflation will be. Or how bumpy. Are we there yet? No, we’re not.

Keeping at it. Jay Powell has said repeatedly the Fed intends to ‘keep at it’ until the job of fighting inflation is done. He continues to channel his inner Paul Volcker. Paul Volcker’s memoir, released a year before his death in 2018, is entitled: Keeping At It. It is well worth the read.

Inflation is a threat to growth and central banks are playing hard to counter it (Figure 2). Mario Draghi’s ‘whatever it takes’ remark about the euro in the European financial crisis has taken on new meaning, not just for the ECB, but for the Fed and BoE as well. 

Monetary policy acts with a lag. First, we see a tightening in financial conditions. That’s followed by a slowdown in economic activity. Finally, we’ll see inflation move lower. But it’s too early for central bankers to be talking about a pivot to cutting policy rates.

The Fed has made clear the greater risk they see is pausing tightening too soon. Taking their foot off the policy brake early might entrench inflation as consumers then expect inflation to be a more lasting problem. Expectations matter and so far, long-term inflation expectations remain in check.

If the Fed overreaches in cumulative tightening, it will force a hard economic landing. In the process, it will have gained the ability to cut rates if needed. Our base case for a soft landing continues to hold, though the glide path to getting there has narrowed.

I can as easily make a case for 10-year U.S. Treasury yields making a run to and through 4.5% as I can a retracement back to or below 3.5%. The interesting thing is I see both happening over the course of the next year. That leaves us neutral on duration. If interest rates press markedly higher, our bias is to lean into core bonds and add to duration.

Keep calm, carry on. The volatility we’ve seen across government bonds and foreign exchange markets has been some of the most severe I’ve seen since the European debt or global financial crisis. I don’t believe we’re heading into a similar environment, but volatility like this usually brings a few market casualties.

I’m surprised we haven’t seen more flash points given high correlations and heightened volatility. If we continue to see these types of market moves, investors will become more skittish. That’s likely to put increasing focus on liquidity and the return of capital, at the expense of price and return on capital.

With market volatility at punishing levels, I’m waiting to see where the next de-leveraging backdrafts appear. I’m keeping a close eye on more aggressive direct and private credit lending markets. Like SPACs, there have undoubtedly been mispriced and badly reserved loans extended at the recent ‘cheap money’ peak. As liquidity is drained, I expect we’ll see a few flash-crashes.

I’m also watching foreign exchange markets. It’s been ‘obvious’ coming into this year that the Fed was going to do the heavy lifting relative to other developed market central banks in rate hikes. The yen, euro and sterling have been ‘safe bets’ to use as a funding source for leveraged carry trades.

While I believe dollar strength continues for a few more quarters, given the moves lower we’ve seen this year in the yen, euro and sterling it’s time to begin to trim back shorts (Figure 3). The easy money has been made. Greed isn’t good when you’re caught on the wrong side of a carry trade and your funding source rallies.

There is rising concern as storm clouds continue to darken across global markets. And yet, the world keeps spinning. I expect companies will continue to highlight a more difficult operating environment and a more defensive outlook. We’re already seeing that.

There is no reason for heroics. While job openings remain strong, we are seeing them being pulled as global PMIs signal weaker activity ahead. We are also beginning to see job layoffs, particularly in the technology sector. We’ll probably see more ahead.

We’ve reduced our equity overweight this year to neutral as storm clouds gathered. First, in the form of far stickier inflation than we expected. We got inflation wrong early this year. Knowing that, we quickly began to pull back risk. As the facts change, you change portfolio positioning. If I look at the equity risk reductions we’ve made this year, we’ve been targeted in when we’ve pulled back – selling into moments of market strength.

We continue to bounce around a 15-18x multiple trading range on the S&P 500. We’re hovering around average historic valuation levels. A mean reverting market happens when investors aren’t sure if the next breakout should be higher or lower. It signals uncertainty. Equity markets are lower, not cheap.

Earnings remain important to watch. I expect we’ll see earnings revised lower over the next few quarters. Companies have been able to pass along all (if not more) of their rising input costs. That’s been a strong driver of operating leverage and outsized earnings growth (Figure 4). Those days are behind us.

Slow-walking new investment. Investors haven’t capitulated on markets. I think rising concern may creep into the market narrative if risk assets fully round trip the wild ride we’ve been on the past few years. Should we broach December 2019 equity market levels, we will have hit ‘rewind’ on pandemic stimulus driven out-performance. That will take time for investors to emotionally process.

The equity market has been reasonably well supported in the face of negative headlines and significant pullbacks in the largest technology companies. A broad trading range for the S&P continues to hold. Downside has held to 3500, with upside I believe around 4000. If inflation continues to surprise to the upside, we may see a new market low. Hopefully the market low is behind us.

James Carville, political adviser to Bill Clinton, is known for two quotes. “It’s the economy, stupid” helped Clinton win the Presidency in 1992. The second remark, made in 1994 as the U.S. bond market was rioting as it is today, proves again to be prescient.

Carville, in watching the power of bond vigilantes demand a return to fiscal orthodoxy, quipped that if there was such a thing as reincarnation he wanted to come back as the bond market. In his words, because you can intimidate everyone. Bond markets lead, risk assets follow. We’re seeing that currently.

As bond yields move higher, I’m tempted to borrow Carville’s campaign slogan about the economy to put in context what markets will be hyper-focused on in the months ahead… it’s inflation stupid. I’m sure that’s how policymakers feel as they continue with their back-to-back rate hikes.

I’ve been asked what I think is similar or different about the current market cycle to other selloffs. This one is particularly passionate because it’s driven by the repricing of policy rates. Policy rates are the risk-free rate that helps price all markets. Investors haven’t seen something like this in decades. We have a challenging and choppy market setting ahead. A market bottoming is a process.