Whatever it takes, no matter the cost?
Whatever it takes, no matter the cost?
Ariel Bezalel and Harry Richards argue that the Fed’s misguided focus on inflation will cause a deep recession – and offers compelling opportunities for fixed income investors.
The US Federal Reserve (Fed) delivered the expected 0.75% interest rate increase at its September meeting, taking the rate to the highest level since 2008, with further hawkish comments about crushing inflation as the Fed’s priority – whatever it takes.
We think this sort of commitment shows flagrant disregard to the collateral damage that may ensue. We have had 225bps of rate hikes over the last three Fed meetings and 300bps this year: this is a huge increase in a short period, especially as the impact is only fully digested 12-18 months down the line. At the time of writing, markets expect the Fed to deliver at least another 120bps of hikes, capping out at 4.6% early next year. Real interest rates, or the yield on a bond after accounting for inflation expectations as priced by the market, have also increased significantly.
We think that posterity will view this period of central bank policy as a series of terrible mistakes. Inflation has been more stubborn than many investors – including us – expected, but it is clearly slowing. Global recession is certain. Central banks and governments have achieved an enormous amount of tightening already: over 300 rate hikes across the world since Q1 2021, reductions in fiscal spending, a much stronger dollar (the broad dollar basket is now at levels we last saw briefly in the early 2000s, and before that in the early 80s) tightening financial conditions, and huge wealth destruction from falling equity and bond markets across the world. Tightening policy further from here through rate hikes and tapering will cause an unnecessarily deep and painful global recession.
We think this sort of commitment shows flagrant disregard to the collateral damage that may ensue. We have had 225bps of rate hikes over the last three Fed meetings and 300bps this year: this is a huge increase in a short period, especially as the impact is only fully digested 12-18 months down the line. At the time of writing, markets expect the Fed to deliver at least another 120bps of hikes, capping out at 4.6% early next year. Real interest rates, or the yield on a bond after accounting for inflation expectations as priced by the market, have also increased significantly.
We think that posterity will view this period of central bank policy as a series of terrible mistakes. Inflation has been more stubborn than many investors – including us – expected, but it is clearly slowing. Global recession is certain. Central banks and governments have achieved an enormous amount of tightening already: over 300 rate hikes across the world since Q1 2021, reductions in fiscal spending, a much stronger dollar (the broad dollar basket is now at levels we last saw briefly in the early 2000s, and before that in the early 80s) tightening financial conditions, and huge wealth destruction from falling equity and bond markets across the world. Tightening policy further from here through rate hikes and tapering will cause an unnecessarily deep and painful global recession.
Too much fear of inflation
Why then is the Fed so hawkish? It is too afraid of inflation, in our view. We also believe that Chairman Jerome Powell is concerned about repeating the mistakes of the Fed in the early 1970s, when they failed to stamp out inflation. That is not to downplay the price rises we have seen this year, which have had a very material impact on families, consumers and companies. We have seen higher food bills, galloping commodity prices – especially natural gas, which is a huge problem in Europe. However, the factors that have been driving inflation are not structural and are already starting to fade.
In 2021, the key driver of inflation was post-Covid supply chain problems. Those have subsided. This year, the driver was war in a crucial region (Ukraine/Russia) for agriculture and energy. Natural gas prices have more than doubled this year, and at its peak oil rose by just under 50%. Throughout the period, we have seen post-Covid disruption to the labour force further increasing costs on companies. Those higher input costs – energy, labour, food – have fed into prices across the globe.
Inflation is easing
The inflation we see now is mostly in the rear-view mirror; looking forward through the windscreen, it is slowing. Covid disruptions such as queues at ports and supply chain problems continue to ease. Shipping rates are collapsing. Commodities (aside from natural gas) have fallen a long way from their Q2 peaks. As the cost of living increases and consumers move from spending stimulus cheques to exhausting credit (a trend evident in US data), we expect to see people coming back into the workforce. These indicators give us high conviction that inflation will decelerate – and indeed that is shown in long-term inflation expectations, which are far from unanchored from central bank targets, and have been declining. For example, one- and two-year US breakevens, which reflect market expectations of inflation in that period, have tumbled in recent months. It is also worth highlighting that money supply growth, six months annualized, is running at nearly -1%. As the Fed tightens further, this number is likely to move even lower.
Inflation may take some time to come down. Year on year numbers are still affected by base effects. The most recent CPI print was higher than forecast. Much of that upside surprise was caused by shelter (housing/rent), which makes up around 30% of core-US inflation, and in particular owner-equivalent rent (OER). Shelter inflation is “smoothed” and is sticky. US housing is slowing significantly, because higher mortgage rates and higher prices have pushed housing affordability to levels we have not seen since before the global financial crisis. OER will come down in due course. It is also worth noting that we have not yet seen lower commodity prices translate fully into lower prices at the pump or in shops.
Inflation may take some time to come down. Year on year numbers are still affected by base effects. The most recent CPI print was higher than forecast. Much of that upside surprise was caused by shelter (housing/rent), which makes up around 30% of core-US inflation, and in particular owner-equivalent rent (OER). Shelter inflation is “smoothed” and is sticky. US housing is slowing significantly, because higher mortgage rates and higher prices have pushed housing affordability to levels we have not seen since before the global financial crisis. OER will come down in due course. It is also worth noting that we have not yet seen lower commodity prices translate fully into lower prices at the pump or in shops.
Truly terrible data
We can already see a path to much more moderate inflation over the next 6-12 months. What this analysis does not yet capture is that recession will cause inflation to slow even more rapidly. Looking over the last 100 years, recession leads to a decline in inflation of just under 7%, on average. In 2008, it took eight months for inflation to decline from nearly 6% to comfortably in deflation territory. Even in the 1970s, when the world faced much stronger structurally inflationary forces such as baby boomers joining the workforce, and far less global debt, recessions caused inflation and bond yields to collapse.
The reasons to hope that global economic growth can be sustained are backward looking and not supported by current data. While jobs numbers in the US have been robust, we are also seeing people taking second jobs to cope with higher costs. Forward-looking indicators look truly terrible. Over 40% of countries’ Purchasing Managers’ Index (PMI) data is under 50, indicating contraction in economic activity. Looking at new orders data, which leads PMIs, the percentage of countries showing contraction jumps to over 70%; this suggests further weakness ahead. We mentioned earlier the collapse in shipping rates, and housing: monthly US mortgage applications have fallen to their lowest levels since 2015. And where US housing goes, so goes employment and broader growth.
The chart below shows the relationship between housing sentiment and the labour market in the US. Housing is also weakening in Australia, Canada, South Korea, Sweden, and many other countries. Over the last 75 years, when the unemployment rate has risen more than 0.5% there has been a recession. Whilst the cost-of-living crisis is hugely damaging, a looming recession with rising unemployment is far more devastating.
The reasons to hope that global economic growth can be sustained are backward looking and not supported by current data. While jobs numbers in the US have been robust, we are also seeing people taking second jobs to cope with higher costs. Forward-looking indicators look truly terrible. Over 40% of countries’ Purchasing Managers’ Index (PMI) data is under 50, indicating contraction in economic activity. Looking at new orders data, which leads PMIs, the percentage of countries showing contraction jumps to over 70%; this suggests further weakness ahead. We mentioned earlier the collapse in shipping rates, and housing: monthly US mortgage applications have fallen to their lowest levels since 2015. And where US housing goes, so goes employment and broader growth.
The chart below shows the relationship between housing sentiment and the labour market in the US. Housing is also weakening in Australia, Canada, South Korea, Sweden, and many other countries. Over the last 75 years, when the unemployment rate has risen more than 0.5% there has been a recession. Whilst the cost-of-living crisis is hugely damaging, a looming recession with rising unemployment is far more devastating.
Where housing goes employment follows
As at 08.31.22. Source: Bloomberg
Company earnings have so far been relatively resilient, but they are another backward-looking indicator. Consumer spending is under huge pressure from the inflation, which combined with the negative wealth effect of stock and bond market moves and a slowing housing market, has caused a collapse in consumer sentiment. Under the surface, consumer spending has seen a transition from spending based on pandemic-era stimulus cheques to credit card and other debt. This consumer balance sheet deterioration will feed through to earnings. We are seeing the first signs of this already with companies such as FedEx, Meta and Boeing announcing job cuts. Consumer-facing companies like Walmart and Target are preparing to cut prices to shift inventory. This will worsen.
Weaker China
We are also very concerned about the long-term impact of China on global growth. The rate of deterioration in China’s demographics in the next decade or two is frightening; it is faster even than Japan, South Korea and Europe. The cost of dealing with the overhang of China’s real estate debt bubble is immense: we expect China to try to “muddle through” at the expense of materially lower growth. The country’s zero-Covid policies do not help, either. China will not rescue global economic growth this time, and it will be particularly hard for emerging market countries and those like Australia with close ties to China.
This year has been one of the most difficult we are likely ever to see in fixed income given the leap in rates and widening spreads. As we head towards the fourth quarter, bond yields are telling us that inflation will keep the Fed tightening, and equity markets are indicating a relatively soft landing. Our analysis provides a different perspective.
There is a significant lag between action and effect in monetary policy: the Fed and other central banks have already tightened more than enough to slow inflation and cause a recession, but they continue to tighten because the impact of what they have already done has not come through yet. Critically, as this chain of events unfolds, it will re-introduce the negative correlation between government bonds and risk assets that has been absent from markets for the last 12 months.
This year has been one of the most difficult we are likely ever to see in fixed income given the leap in rates and widening spreads. As we head towards the fourth quarter, bond yields are telling us that inflation will keep the Fed tightening, and equity markets are indicating a relatively soft landing. Our analysis provides a different perspective.
There is a significant lag between action and effect in monetary policy: the Fed and other central banks have already tightened more than enough to slow inflation and cause a recession, but they continue to tighten because the impact of what they have already done has not come through yet. Critically, as this chain of events unfolds, it will re-introduce the negative correlation between government bonds and risk assets that has been absent from markets for the last 12 months.
What it means for investors
What does that mean for markets and our portfolios? First is a high conviction that we see much lower bond yields as the Fed pivots in the face of deep recession, and the “whatever it takes” narrative pivots from beating inflation to avoiding economic depression. Today’s excess rate hikes will lead to even lower yields tomorrow. That makes high-quality medium and long-dated government bond yields in the US and Australia incredibly compelling. While equity markets look complacent, credit markets look to have better priced a recession, and parts of the credit universe are looking more attractive — even if there will be volatility to come. The advantage that fixed income investors have is that by picking the right credits and avoiding defaults, we can already start to access incredibly compelling yields. While the global economy faces a rough ride, the best opportunity to buy fixed income in a generation is upon us.
Sources for all data are Bloomberg, as at 23 September 2022
Sources for all data are Bloomberg, as at 23 September 2022
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