November 16, 2022
Given the challenging year markets have experienced so far in 2022, you might be wondering if we have seen the worst of it. The short answer for the economy: No. A recession still looms ahead as we enter 2023. But for markets: Maybe. A lot has clearly been priced given the significant bear markets in both stock and bond markets this year.
Who do we have to thank? Inflation.
The key driver for markets in 2022 has been the aggressive tightening of monetary policy as central banks ramped up interest rates in response to much stronger and persistent increases in inflation.
Developed market central banks, including the FED in the US and the Bank of Canada, are charged with maintaining price stability, defined by an inflation target of 2%. With inflation rates spiking up into the 4%-8% range (depending on which inflation metric one looks at), central banks have no option but to use the tools at their disposal to bring inflation levels back down toward their targets.
Interest rates are their key tool, and central banks have spent the year accelerating the trajectory of the rate path higher. Starting with overnight rates at zero, they began hiking rates in March and are now at 3.75%-4% with expectations of being between 4%-4.5% by year end. Ouch!
There is little doubt that interest rates at these levels will have a dampening impact on the economic outlook into 2023. We fully expect both the US and Canada will see recessions next year. With inflation way above target and near record low levels of unemployment, any conventional economic analysis would dictate that a recession is an unfortunate but necessary cost of bringing inflation back towards the 2% target.
Failure to rein in inflation today would have far greater adverse impacts on the economy and employment in the future. This was a key lesson from the 1970s when failure to harness inflation for over a decade ultimately led to the embedding of double-digit inflationary pressures into the economy and the severe recession and double-digit interest rates of the early 80s.
Better to weather a mild recession today than risk a repeat of the late 70s. Such is the motivation behind the aggressive pace of monetary tightening seen throughout the past year.
Don’t Fight The FED
It was a year ago the FED started to signal the need to begin tightening monetary policy from the pandemic-induced uber-low level of 0-0.25%. Throughout the year, the FED continued to escalate the expected pace of tightening as inflationary threats grew stronger.
This precipitated the ongoing sell-offs in both fixed income and equity markets as bond markets were continually forced to reprice the yield curve for a faster pace and a ‘higher for longer’ terminal rate. It has been a yearlong battle, the FED versus the Bond Market. The FED, backed by strong inflation data, has relentlessly dragged the bond market, kicking, and screaming, to reprice the more hawkish outlook.
Resetting overnight rates from zero to 4% and the 10-year bond from 1.5% a year ago to over 4% has been a painful ride for investors who have seen double digit declines in both fixed income and equity markets. While the impact on the underlying economy from such moves will continue to play out, with time lags of a year plus, asset markets reprice much faster. There is a strong likelihood that we have seen the worst of the sell-off in both bond and equity markets.
While there are clearly still risks and volatility ahead with a recession expected in 2023, we appear to be in a bottoming process and may have already seen the bottom for both bonds and equities. From here, a bounce and grind sideways seem more likely than an all clear and off to the races for markets. The reality for markets and policy, will ultimately depend on the path of upcoming data, particularly related to inflation and earnings, but there are reasons to be hopeful.
Is that you, Santa Claus?
Three recent developments, plus timing, lead us to be more optimistic on markets into year end:
Firstly, in October, following a couple of hawkish hissy fits from Fed Chair Jay Powell, bond markets started pricing a more aggressive path than that indicated by the FED for the first time this cycle. Markets bought into the FED’s ‘Kill Inflation Now!’ message and started pricing an even higher and longer outlook for interest rates than current FED guidance. This is constructive.
If the FED delivers on their guidance, it is a positive surprise for markets, and if they raise their rate outlook further, they are merely marking to market. This is the polar opposite to the risk/reward setup that has existed between the FED and markets all year.
Secondly, at the November FED meeting, Jay Powell successfully stepped down the expected pace of rate hikes from 75bp per meeting to 50bp for the upcoming December meeting. While Jay did indicate an expectation to end up at a higher terminal rate, the first step off the tightening cycle hamster wheel is to slow down the pace. The second step is to pause hikes, and the third, cut rates. Step one accomplished.
As always it remains data dependent, but we now require significantly stronger-than-expected inflation data for the FED not to step down the pace to 50bp in December. By the same token, further expected hikes in 2023 will require sufficiently strong inflation data to proceed.
My personal forecast at this point is that weaker-than-expected economic and inflation data by Q2/23 will see the FED hitting the pause button sooner than they currently expect.
Finally, October Consumer Price Index (CPI) data fell for the fourth consecutive month and came in well below expectations. For most of the past year markets and policymakers have been confounded by stronger-than-expected inflationary data, as transitory pandemic related impacts on both the supply and demand sides have proved more resilient and slower to unwind than originally expected. We finally got some relief with the October data. One month of weak data, on a notoriously fickle data series, is not even remotely sufficient to begin to think about declaring inflation under control.
It is nonetheless a respite from the serial inflation disappointments and is consistent with the path one should expect for inflation given policy tightening and supply side improvements. The November data to be released on December 13th will take on outsized importance. But for now, that remains a month away.
Markets hit recent lows, while rates hit recent highs in October. With the November Fed meeting and stepdown behind us, with US midterms behind us, with a positive inflation surprise on the tape, we now enter the most positive seasonal time for markets with market participants and positioning in extremely bearish moods. The stars would appear well aligned for a Santa Claus rally into year end, or at least until the inflation date on December 13th.
Upcoming economic and inflation data will ultimately determine if we have seen the lows of this bear market. With a recession and falling earnings expectations ahead, it is certainly not an all-clear signal heading into 2023, so caution and capital protection remain top of mind. But tactically the risk-reward in markets also dictates selectively adding exposure to risk assets. From a defensive underweight exposure to equities, we have recently increased our equity exposure back up toward neutral.
War on Savers is Over!
If there is a big silver lining to the market mayhem in 2022, it is that the decade long war on savers is over. Interest rates and bonds are back to being attractive investment options for investors looking for income. For much of the past decade with interest rates at and below the level of inflation, (i.e., negative real interest rates), savers had no truly low risk alternatives for either generating income or protecting the purchasing power of their savings. Negative real rates are the true enemy of the retirement savings industry.
As painful as the reset process is for existing fixed income owners, the options in fixed income on a forward-looking basis have not been this attractive in well over a decade. With government bonds yielding 4s, investment grade yielding 6s and high yield offering 9s, I can truly say that for investors and for income generation, Bonds are Back! That is saying something coming from one who has spent three decades in global equities!
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Published November, 15, 2022