The Slope of Hope

WED 13 APR 2022

The recent market obsession – inflation – wasn’t quite as bad as feared, with the core reading falling well short of the consensus forecast on a monthly basis. The bad news is that the distribution or breadth (based on the trimmed mean) was uncomfortably high and the headline was very awkward for the Administration. After all, households still need to eat and consume energy. While there is some hope that inflation is near a peak, the big picture point for markets is that it is way too high for the government and therefore the FOMC. The Federal Reserve is still likely to hike by 50 basis points in May and start the process of quantitative tightening.

Given the magnitude of the recent sell off in fixed income (the largest drawdown in more than 20 years in total return terms) it was probably not a surprise how price/yield responded to the below consensus reading. That suggests as much about the market’s prevailing bias and positioning as it does about economics. Perhaps more notable was the fade of equity prices into the US close, especially in duration sensitive sectors. There a few key points to note.

First, as we highlighted above, while there was a modest downside surprise on core, the distribution or breadth of price gains in the trimmed mean measure was still very high (0.55% on the month and 6.1% on the year – chart 1). Headline inflation also reached a new cycle high at 8.5% year on year or the highest since 1981. The last time inflation was this high, the policy interest rate was over 10%. The big picture point is that the Fed has a lot of work to do. Second, communication from the Fed (especially the more dovish members of the FOMC) has reinforced that observation. Inflation has become a political challenge for the administration and the Fed, reinforcing the need to act on both rates and QT of the balance sheet.

Third, the challenge for equities and credit is that the Fed will be forced to hike rates and withdraw liquidity into a cyclical slowdown. As we have noted recently, a number of the best leading indicators of the cycle are consistent with a growth scare later this year. That observation was reinforced by the NFIB Small Business Survey overnight as well (chart 2). To be fair, the latest Bank of America Fund Manager Survey suggests that the growth scare is a very widely held consensus belief. Nonetheless, it is also notable that equities are still only 9% below the record high or not really priced for recession.

In conclusion, while policy tightening in response to inflation and a growth scare is the prevailing bias among investors, we are not convinced that it is adequately priced into the global risk proxy (the S&P500). Very few investors today experienced the 1980s inflation/rates episode and our sense is that there is still a desire to return to the pre-COVID market regime that was characterised by macro (and inflation) stability. However, inflation and economic volatility has probably also shifted the market regime away from a low volatility grind and out performance of long duration growth assets. In the current regime, investors ought to have a preference for cash flow, balance sheet strength and a decent margin of safety. As we noted yesterday, the upcoming reporting season starting today will also likely be illuminating on the impact of rising input costs and profit margin pressure.