The Battle between the Hawks & the Doves

THU 04 AUG 2022

Over the past few weeks while your humble student of the markets was away from the screens there has been an intense battle between the inflation hawks and doves. The latter have highlighted the clear deterioration in the lead indicators of the macro cycle and the moderation in commodity prices that tend to drive headline inflation. While the former, led by members of the FOMC, have pushed back on any near term pivot by the Federal Reserve. Put another way, forward guidance as a policy tool might not be dead just yet. The big picture point for markets is that central banks will continue to hike rates until there is a meaningful moderation in the pace of inflation. That will probably lead to further tightening in financial conditions and a profit recession (which is more important than a “technical” recession as defined by the NBER for equities).

From a macro perspective, one of the key developments over the past month has been the moderation in key drivers of headline inflation. A decent proxy for that is the US ISM prices paid sub index which tends to lead headline inflation (goods and commodity prices) by around 3 months (chart 1). Of course, on the negative side, there is also likely to be a corresponding slow down in growth and corporate earnings.

The additional challenge for the inflation doves as expressed by the FOMC is inflation breadth in this episode. That is evident in the Cleveland Fed’s trimmed mean measure of inflation (chart 2) which suggests that broad-based inflation is materially higher than the average of the last 20 years. Stated differently, the inflation problem is considerably broader than a simple supply driven episode and underlying measures of core inflation are likely to remain more persistent even if there is a cyclical moderation in goods or commodity price inflation.

The key to moderating underlying inflation is easing conditions in the labour market. The Fed would prefer to ease labour market conditions through an increase in the supply of labour (participation). However, tighter financial conditions will ultimately lead to slower final demand and rising unemployment. The labour market is a lagging indicator of the macro cycle. A key reason why the Fed pushed back on a “dovish pivot” over the past week is that current conditions in the labour market remain firm (at peak levels based on the Kansas Fed – chart 3). Of course, tighter financial conditions suggest that labour market will deteriorate over the coming months. That is also consistent with the more timely jobless claims data which has already started to trend higher over the past two months.

For equities or the global risk proxy (S&P500), this suggests that further tightening of financial conditions (with the Fed endorsing 3.5-4% Fed Funds Rate by year end). Moreover, the tighter financial conditions are likely to contribute to a deterioration in final demand, sales volumes and corporate earnings. While the former is well priced and reflected in the P/E valuation multiple, the latter has still not been fully reflected in earnings expectations. This suggests that there is likely to be another phase of weakness (and potentially a new low) in equities over the coming weeks or months. The good news in this region is that considerably more weakness in growth and profits is already reflected in price and valuations (more on that to follow).