THU 16 JUN 2022
The leak to the Wall Street Journal was on Monday ahead of the June FOMC was on the money. The FOMC hiked the funds rate by 75 basis points to 1.75%. Relative to both the prior Fed meeting and consensus beliefs from a week ago the actions and promises by the Fed were clearly hawkish. However, the prevailing bias has shifted considerably over the past few weeks. As we have noted, the short term interest rate markets have the funds rate peaking around 4% by mid-2023 or modestly into restrictive territory compared to neutral (the FOMC estimate that at around 2.5%).
The economic projections underlying the policy estimates do not outline an optimistic endgame from the current policy dilemma. Recall that soft landings are the exception not the rule. Below trend growth through the end of 2023 and rising unemployment suggest that policy will start to restrict macro conditions later this year. Put another way, in the trade off between inflation and unemployment, the Fed will focus on hiking rates until there is a meaningful deceleration in consumer price inflation. In that context, a better way to frame the policy adjustment is that the Fed will continue to hike rates until inflation slows or something breaks. From our perch, we will only know much policy tightening is required after Treasury yields peak and the curve becomes meaningfully inverted.
As Gerard Minack has noted, equities typically cope with early Fed tightening because earnings growth tends to offset rate-driven valuation compression in an expansion phase. Historically, valuation takes time to adjust because fixed income markets take time to price the ultimately peak in the policy rate. Of course, this cycle has been hotter and potentially shorter with policy conditions held too loose for too long. As a result, the adjustment in expectations this cycle has been so fast that earnings growth has not offset the rapid valuation compression.
The positive forward looking point is that consensus beliefs on peak rates in this cycle are now well calibrated around 4%. Moreover, valuation compression has already taken valuation back to modestly below neutral (around 16 times forward earnings on the S&P500 or the global risk proxy). On the negative side, valuation typically overshoots equilibrium to the downside and equities will still have to adjust for the probable earnings downgrades to come (chart 1). The good news in this region is that the process is further advanced with valuation much closer to trough levels. However, we still fear further downside adjustment in the global risk proxy.
In spite of negative sentiment and positioning, the path of least resistance is still likely to be lower. However, tactically there might be another counter-trend rally into the northern hemisphere summer. The good news as we noted above, is that the set up from a valuation, sentiment and cyclical perspective is more constructive in Asia.