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Market Thoughts: Recalibrate expectations—growth is still robust but inflation, stubborn

Markets will be orbiting around inflation for the next few quarters. It would be nice to think policy tightening and market pullbacks are ‘one and done’ events. They’re not.

Market Thoughts: Recalibrate expectations—growth is still robust but inflation, stubborn

  • Markets will be orbiting around inflation for the next few quarters. The Fed has its work cut out for it. It would be nice to think policy tightening and market pullbacks are ‘one and done’ events. They’re not.
  • Central banks have pivoted in their easing bombast, with inflation stubbornly high. They’re trying to move fast and not break things. They want markets to do the heavy lifting for them. So far, it’s working.
  • March is going to be an ‘exciting’ month. It marks the next series of policy meetings for major central banks. Between now and then, expect monetary policy to be actively questioned and markets to remain volatile.
  • Getting back to a place where the interest rate landscape begins to look more normal is essential. The bumps along the way are going to feel a little uncomfortable.

It’s been a fast start to the year. We added to our U.S. equity overweight following the late January sell-off, funding it from extended credit. I think it’s important to emphasize that, should the recent market pullback turn into something worse, we are better buyers of risk assets. We remain constructive on the outlook.

For the moment, markets can handle higher interest rates. That effectively translates into investors having confidence in the Federal Reserve (Fed). That said, we’re going to see more turbulence.

The answer to every question is inflation. Markets will be orbiting around inflation for the next few quarters (Figure 1). Outsized demand, impaired supply chains, tight labor markets and omicron have conspired to make the economic data messy to interpret.

Line chart of Global, Euro Area and U.S. Composite Purchasing Managers Index time series with monthly data points that are displayed on the y-axis and since 2019 on the x-axis. A horizontal dashed line shown across 50 separates economic expansion or contraction with above that value representing the former and below it the latter. For the better part of 2019, all economies were hovering not too far above 50, and in early 2020 a marked drawdown occurred across the board, with Euro Area declining the most. However, by mid 2020 all regained expansion but continued on an uneven trajectory coming into 2021, with Europe dipping below 50 again. 2021 saw Composite Purchasing Managers Index across economies remain firmly in expansion, though it has decelerated in recent months.

The Fed has pivoted hard in its policy rhetoric. Some of this is because the inflation data became headline rousing and more problematic. I expect the Fed’s dance with inflation will continue into midyear. If rising inflationary pressure goes beyond that, investors won’t like it. So far, markets are only rumbling.

The Fed is trying to get in front of inflation, signaling that they will tap hard on the brakes if they need to. Though raising rates is their primary inflation deterrent, I believe reminding investors that the Fed’s toolkit is more expansive than simply raising policy rates is important. In my mind, the Fed has accelerated the end of bond purchases to give themselves the flexibility to do more, faster, if needed. They are focused on retaining maximum optionality.

Game on. It’s fair to say that the Fed has met its target for employment (Figure 2). Given where we are with rising inflation, it’s time to begin to tighten monetary policy. An argument can be made the Fed is late to action. Markets expect liftoff at the March 16th policy meeting.

Line chart of U.S., Euro Area and Japan local currency central bank balance sheet growth time series with quarterly data points displayed on the y-axis as indexed to 100 in Q1 2010 and shown since then through Q3 2021 on the x-axis. While divergent in the first few years shown, all regions show significant growth in total over the last decade and an accelerating pace of growth since around the start of 2020. Japan shows the largest relative increase over the time horizon at almost 600, followed by Europe and then the U.S. respectively above and below 400. The U.S. shows a particularly sharp increase in balance sheet growth in 2020, rising by almost 150 in that calendar year.

I keep hearing analysts argue that a 50bps hike from the Fed is likely in March. That is a ‘big ask’ for a first rate hike. Looking back to the early 1980s, we’ve seen periods where the Fed has moved 50bps on a handful of occasions, but only after a hiking cycle had begun.

Jay Powell has signaled a ‘nimble’ tightening cycle ahead. That’s shorthand for a Fed that intends, as best it can, to be front-footed in getting ahead of inflation. For anyone questioning whether Powell has stepped back from supporting markets – the famous ‘Fed put’ – nothing suggests it. What investors need to process is that the strike price for the Fed to act is probably closer to bear market territory. We’re not there yet.

If we are on a path to policy normalization, the Fed has its work cut out for it as it relates both to raising policy rates and reducing the size of its balance sheet. It would be nice to think that tightening and equity market pullbacks are ‘one and done’ events. They’re not. We’re embarking on a process of recalibration.

Déjà vu all over again. Recent policy meetings, both at the Bank of England (BoE) and European Central Bank (ECB), felt – to borrow a phrase – a little like déjà vu all over again. Or better said, Fed redux.

The Fed, BoE and ECB have quickly shifted their easing bombast as inflation remains stubbornly high. Central banks are doing what they should be doing in debating policy options for moving away from very low policy rates (Figure 3). They’re trying to move fast and not break things. Ideally, they want markets to do the heavy lifting for them. Given the move higher we’re seeing in government bond yields globally, that’s exactly what’s happening. Recalibration.

Line chart of MSCI USA, MSCI Europe and MSCI Japan last twelve month net income margins time series shown in percentage terms on the y-axis and displayed on a quarterly basis since 2002 through Q3 2021 on the x-axis. While divergent in level terms with the U.S. being highest at around 12% and Japan lowest at around 6%, all regions show significant margin growth in 2021, most notably in Europe which increased by over 3% to almost 9%. The chart denotes that past performance is not indicative of future returns, and that it is not possible to invest in an index.

March is going to be an ‘exciting’ month for markets. It marks the next policy meetings for the Fed, ECB and BoE. For the ECB and Fed in particular, we get economic projections that will be closely scrutinized. Between now and then, expect monetary policy to be actively debated in the headlines and markets to be hot-blooded. I don’t think there is much argument at this point we’re seeing a regime shift in central bank policy. We’re moving from easing to tightening.

I want to emphasize how important it is for central banks to appear ahead of and not chasing inflation. It’s critical to confidence. Investors don’t like the punchbowl being taken away, but signaling what’s coming reduces uncertainty. Markets disdain uncertainly. Ultimately, a hawkish central bank position is easier to step back from than having to lean further into. Investors really wouldn’t like that. The hawkish drumbeat is going to get a little louder.

A valuation shock. We’ve seen a valuation, not a policy shock. Having some of the more extreme risk pockets of the market sell-off is positive. Take a look at the pressure SPACs and ‘trash-tech’ – with no earnings, bad balance sheets and sky-high valuations – have been under.

The U.S. dollar has been on a tear higher. Some of the dollar’s strength is safe-haven related. Also, the Fed has clearly signaled they are about to embark on a fast-paced tightening cycle, which likely adds further support – at least until the ECB begins to raise interest rates.

Benjamin Graham characterized markets as voting machines in the short-term and weighing machines in the long run. We’ve seen selling (voting) to reduce overvalued high-beta risk positions. That said, it’s important to point out that a lot of the selling is motivated by investors rationally looking at extreme market valuations. They’re weighing, which is a very healthy signal.

A dash from trash – in the form of overvalued non-earnings generating high-beta stocks – is warranted. It hopefully signals the beginning of the end of free money. Pressure on small cap stocks also makes sense. They’re expensive, highly leveraged and continue to suffer from margin pressure, in particular as interest rates press higher.

As investors vote, markets weigh. It’s constructive to see speculative risk assets sell off. They’ll live to fight another day, but it helps to put risk assets that warrant their valuation levels in perspective. Taking some froth out of exuberance is never a bad thing, though it can add to uncertainty.

Steady hands prevail. I expect mid-to-high single digit corporate earnings growth this year for the U.S. as well as Europe. There is upside in that outlook. I’d rather be positively surprised. With muddy waters around the inflation outlook and central banks in motion, I prefer to be cautious.

Revenue and earnings growth ahead gets more challenging as ‘easier’ 2020 pandemic lockdown comps roll off. There is nothing negative in that observation. And to be clear about how to interpret that remark, I’m managing expectations to lower positive – but not negative – equity market returns. Don’t expect a repeat of last year.

As we see inflationary pressures roll over and above trend growth hold, risk assets should move higher. The key for equity markets is inflation. Real rates are working their way back towards positive territory. In turn, the percentage of negative yielding bonds globally is shrinking. Bulls will miss TINA, or the idea that ‘There Is No Alternative’ to holding risk assets in a zero central bank policy rate world. The investment landscape is reverting back to normal.

Getting back to a place where the interest rate landscape begins to look more typical is essential. Negative real interest rates aren’t usual. That said, the bumps along the way are going to feel a little uncomfortable. The data point I‘d like to see us land on late this year is core U.S. inflation right around 3%. If you look back at prior cycles, equity market valuations tend to have more support when inflation stays below 3-3 ½%. In particular, with above trend economic growth.

We’ve seen forward earnings for equity markets derate by several multiple points. Stability and any modest rerating will depend on the strength of 2023 earnings and central banks getting inflation and real rates back in line. Steady hands prevail.

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