WED 06 APR 2022
From our perch, the communication from the Fed’s Brainard overnight was thick with irony. As my Italian friend noted, I never thought I would live to hear Brainard (one of the most dovish members of the FOMC) quoting Volcker. It smacked of desperation given the recent news flow on inflation. It was ironic for two reasons. First, the policy error was leaving monetary normalisation so late. Second, the best leading indicators of the cycle (including the ISM, and yield curve) suggest that growth is starting to deteriorate just as the Fed becomes hawkish.
The big picture point is that the Fed is likely to start reducing the balance sheet or implement quantitative tightening in addition to a more aggressive hike in short term policy rates. Recall that the shadow Fed Funds rate (that estimates the impact of the balance sheet on the policy rate) has already led to approximately 200 basis points of effective right hikes. If the Fed delivers 100-150 basis points of additional rate hikes and a “rapid” reduction in the balance sheet over the coming months, financial conditions are likely to tighten materially in relatively short order.
For markets, this leaves us relatively cautious on risk assets. In a typical cycle it is common for equities to cope with higher rates (when accompanied by strong profit growth) or until rates move above neutral. However, from our humble perch, this cycle is atypical or probably compressed relative to previous episodes. Moreover, there is evidence to suggest that earnings are likely to be revised meaningfully lower over the coming months from slower revenue and input cost pressure.
In addition to the decline in ISM new orders relative to inventory and flattening of the yield curve, the performance of cyclical to defensive sectors has also deteriorated (chart 1). There has also been a notable drawdown in transportation stocks (which are also sensitive to the business cycle) over the past week (-9% in the past week). Also note that US banks have rolled over, counter to the move higher in Treasury yields. The way price has responded to news is not bullish.
The good news is that the deterioration in final demand will likely ease some inflation pressure over the coming months. Mathematically, it is also probable that year on year headline inflation is near a peak. However, we fear that the Fed is becoming aggressive into a deteriorating growth environment. However, the policy error was already committed by normalising so late in this cycle. In this context, cash provides optionality and the cost of protection in credit, for the potential pay-off is probably still cheap. Stated differently, should we not fight the Fed only when its friendly?
In conclusion, we are raising additional cash today and reducing net exposure in equity.