No Love for Dove

The November FOMC is shaping up as one of the more eventful meetings of Powell’s tenure at the helm of the Fed. As we have noted over the past few weeks, there has been a capitulation in beliefs on the path of future expected short rates (note Goldman’s forecast adjustment last Friday which moved them closer to consensus). Market pricing appears pretty extreme in the near term. However, in the medium term our sense is that the prevailing bias on the terminal rate or post 2008 regime has not adjusted yet.

While a secular shift higher in rates is still open to debate, what we do know is that it would be pivotal for market pricing and broader asset allocation (the correlation between fixed income and equity and the capacity of sovereign bonds to diversify equities). Investors of a more mature vintage might recall the Bank of England moving the policy rate several hundred basis points intra-day on multiple occasions during the episode in 1992. In that context, the debate over 75 basis points in 12 months’ time appears fairly trivial. Of course, cross asset valuations and system wide leverage are a lot higher today.

Central banks probably overestimate the impact or importance of a balance sheet shift or 25 basis point hike on the real economy. For example, would a 25 basis point hike really affect the capital investment decision of the major US corporations like Apple and Amazon who are net cash on balance sheet? Probably not. Although the start of Fed policy tightening has coincided with increased equity turbulence (volatility) in the past (chart 1). Chairman Powell will have to walk a fine line to convince financial markets that rate hikes are not justified in the short term given the clear acceleration in employment costs (evident in the data on Friday) and other inflationary pressures which to be fair have been driven by supply side or supply chain disruptions.

In late September and early October, investor sentiment had become too pessimistic on US growth (impacted by the delta variant) and China (related to the credit slowdown and episode in real estate credit). However, most US gauges of sentiment have recovered sharply over the past month after the 7% rally in the S&P500 (the global risk proxy) and EPS that have mostly blown away expectations. In this region our sense is that investors had also become too pessimistic on China’s near term growth prospects which is typical at the weakest point in the credit impulse. Although the medium term challenges to China’s growth model are very real. The current weakness is likely to be met with policy (liquidity/credit) easing by the PBOC to support growth and likely explains the recent improvement in cyclical performance.

History strongly suggests that investors ought to have a pro-cyclical bias into year end and that the markets will probably look through the short term challenges and shift in central bank bias. While the FOMC is likely to initiate the taper of asset purchases this week it is important to note that Fed tightening does not imply an end to the equity bull market. However, the start of Fed tightening has in the past coincided with a phase of increased volatility for equity.

It is also important to note that macro conditions have already passed peak momentum. ISM new orders minus inventory leads the headline index by around 3 months (chart 2). In turn that is a decent lead indicator of activity and earnings revisions. That suggests the Fed will also face a deteriorating growth/inflation trade off as we move into 2022 and again begs the question of whether the Fed has been too slow to normalise policy in this cycle. In the short term, our sense is that a pro-cyclical bias remains warranted given the stage of the cycle and the still abnormally high equity risk premium. However, we anticipate a phase of increased turbulence as policy is normalised. That is also evident in other fixed income markets around the world.

Looking further out, if there has been a secular pivot in trend inflation and rates, that would have profound implications for long duration assets. While we retain a positive pro-cyclical basis on (and within) equity, companies with strong free cash flow and balance sheets are more likely to out perform long duration assets based on “hopes and dreams” as we enter the rate normalisation phase of the cycle. Moreover, although rates markets might be too aggressive relative to likely policy in the near term, the prevailing bias on medium term (terminal) rates is likely to complacent. Particularly if there is a genuine wage-inflation driven cycle ahead. In that type of regime sovereign fixed income will not diversify equity given the low starting point for real yields.

Of course, higher system wide leverage suggests that rates might also struggle to reset materially higher without consequences for highly levered assets. That is a key consideration for 2022 and beyond. What would provide “diversification” for equity would be a long position in volatility (where the premium for pay-off is most attractive). In the near term, that is in developed market credit.