Fire in the - Jackson - Hole

TUE 30 AUG 2022

Immediately following the July FOMC meeting, the prevailing bias appeared to shift to the belief that the Fed had executed a “dovish pivot.” Our sense at the time was that this was a heroic interpretation given the level of headline inflation, inflation breadth (as measured by the trimmed mean) and the policy rate in that context. The subsequent communications from FOMC members suggested that nothing had really changed about Fed policy and that one low inflation print was unlikely to convince the Fed that that trend had turned yet. In short, the FOMC was always likely to require further evidence of a meaningful deceleration in consumer prices before adjusting the current path of monetary policy.

That hawkish message was clearly reinforced by Chair Powell last Friday at Jackson Hole. The language was very intentional and clear with terms like “forcefully, purposefully, unconditional” highlighting the conviction and commitment to moderate inflation. The way price responded to the language was probably reinforced by the observation that the Fed expects the economy to eventually suffer from restrictive policy but that is more acceptable than premature relaxation of policy. Stated differently, the Fed is willing to sacrifice growth in order to get inflation under control. Higher-for-longer is also not a message that 10-year market veterans are accustomed to dealing with, hence why Powell was so unambiguous in the message.

In the very near term, short term interest rate expectations appear priced for the Fed to deliver another +75 basis points in September and rates are now anticipated to remain higher-for-longer through 2023. From our perch, that path will likely depend on how rapidly growth and inflation deteriorate over the next two quarters, but it increases the probability of a genuine growth shock next year. The big picture point here is that the Fed will likely err on the side of vigilance rather than premature relaxation of short term interest rate expectations and financial conditions.

For equities, the adjustment (so far) this year has been entirely driven by valuation multiple de-rating. Indeed, the multiple compression in this episode has been one of the most severe since the 1960s. However, the forward looking challenge is that has only taken the S&P500 forward P/E back to the long term average (or around neutral). Second, our sense is that the aggregate earnings downside risk is not adequately priced. The speed and magnitude of the tightening in financial conditions suggests that there is material downside to EPS over the next few quarters (chart 1). That observation is reinforced by other leading indicators like the ISM new orders to inventory ratio, for example. To be fair, underneath the surface, there has been a much larger adjustment in rate sensitive (profitless equity) and EPS ex energy has been weaker than the S&P500 total including energy.

In Asia, the good news is that the valuation adjustment commenced much earlier (in February 2021) and has been much deeper. Asia Pacific is much closer to trough valuation and is now trading at the largest discount to the United States since the 1997 crisis (in relative to book value terms). The final point to note is that China has clearly shifted policy (credit and liquidity) to easing mode. While that is necessary given the material weakness in current activity, it should start to support regional equities into the end of 2022. However, in the very short term, the odds of the Fed over-tightening and a hard landing have increased. That is probably challenging for the global risk proxy (the S&P500) and equity bulls.