“And are you shoppin' anywhere, Changed the colour of your hair, are you busy?“
The Zutons, Valerie
In our last piece, prior to the brief summer interlude, we discussed the composition and market reaction to the US inflation reading for July and went on to argue that it is increasingly likely that as supply and demand continues to normalise (and from our perspective the prospects of significant further disinflation are increasing), that growth will increasingly become the dominant macro driver - and thus should be the dominant focus.
After core CPI posted the smallest back-to-back gains in over two years on a monthly basis, in July, we argued that data also showed that nine tenths of the increase in overall CPI was due to housing costs which are a lagged indicator and thus widely expected to continue to decline through the rest of 2023. Further, amid a wider market (and seemingly also internal Fed) debate about the lags of monetary policy and thus the implications for the forward Fed Funds path (and by extension for bonds, currencies and risk assets), we argued that that a number of factors including the huge pandemic fiscal stimulus (and ongoing significant fiscal deficit) in the US likely imply longer lag times, as excess savings have delayed or damped the impact of tighter monetary policy in the near term. Furthermore, we also argued that the impact of higher rates in and of themselves (let alone the lag with which they occur) is long lasting - likely so too the impact of higher nominal prices. These factors likely all add downside growth risks to the macro composition.
Essentially this is an extension of the relative vs. absolute debate that we have raised on a number of occasions this year. In our view many market analysts have emphasised (and continue to do so) the impact of relative movements in indicators such as Financial Conditions Indices (FCI) - essentially arguing that because financial conditions are not getting any tighter, the net impulse is positive for growth. We disagree. In fact, we would argue that the absolute level of broad financial conditions high levels of interest rates, historically high levels of prices and high absolute levels of taxation (though the tax level argument is substantially more compelling in the UK) maintain if not continue to support the restrictiveness of financial conditions - at least in the near term.
In the short break since we last wrote there are a number of points worth reviewing in relation to our broader views and the data / event evolution:
The first is the Jackson Hole commentary from the Fed Chair. While the consensus tone of the reports on the Fed’s Chair commentary implied a hawkish bias on the basis that he stated inflation, while lower, remains too high, and that the Fed would be prepared to raise rates further if required. We would argue that the Chair of the Fed’s testimony was significantly more balanced and at the very least, relative to the price action along the US yield curve going into the meeting, dovish.
Indeed, in relation to expectations going into Jackson Hole (expectations that ranged from discussions around a formally higher equilibrium level of rates, or r*, a raising of the inflation target and even an explicit narrative around the need for higher rates due to a re-accelerating economy), the Fed’s Chair comments were in our view more balanced in terms of growth and inflation risks going forward. The Chair of the Fed was explicit that real rates are positive and well above neutral estimates (i.e restrictive), and that 2% is, and will remain the inflation target. He also recentred growth in the debate with the statement “evidence of persistently firm growth could put further progress on inflation at risk.” - the opposite is also true.
We would be sympathetic to the concept that the Fed’s narrative is intentionally biased towards the hawkish side at the current juncture as a function of preventing market expectations easing policy pricing too quickly further out the curve - potentially encouraging a more resilient demand that adds to the persistence of inflation - as Chair of the Fed alludes. However, outside of the communication preferences of the Fed we remain of the view that the underlying momentum of demand is significantly weaker than the current data currently implies. Whether this is a function of the lags of the huge pandemic fiscal stimulus (on households and local government), or the distortion of current government programmes such as CHIPS, IRA and the Infrastructure bill - that have (among other things) positively distorted inward investment - remains unclear.
We remain of the (admittedly surprisingly still unfashionable) view that disinflation will continue significantly through the rest of the year and that deflation (at least in parts of the basket) are distinctly possible in 2024.
“...so the idea that we would keep hiking until inflation gets to two percent would be a prescription of going way past the target. that’s clearly not the appropriate way to think about it ... because, you know the federal funds rate is at a restrictive level now.” ( Chair of the FedJuly FOMC Mins)
- this has significant policy implications in a global financial market backdrop that appears increasingly of the view (and thus positioned?) for a reacceleration of growth.
The other key market focus over recent weeks has been the growth backdrop more explicitly. Notably the very weak German PMI data for July - but PMI data globally gave a much more modest indication of current global growth momentum. Indeed, earlier this week we have seen JOLTS data from the US that highlight a further, large softening in the US labor market (job openings per individual fell to its lowest level since September 2021 and the quits rate - seen as a gauge of the strength of demand for labour - fell back to pre-pandemic levels). Alongside JOLTS, the conference board consumer confidence index fell back sharply, at least in part driven by job market perceptions.
As we move into September, and the Labor Day Holiday in the US, this traditionally significant point in the year (highlighted in the stock market maxim “Sell in May and go away, come back after Labor Day), we expect growth to be an increasing focus for financial markets. From our perspective the concept of a soft economic landing and hard inflation landing seems most appropriate in the US, but all countries are not equal.
If we are right and markets become increasingly focussed on demand growth, perhaps we should ask around - “And are you shoppin' anywhere, Changed the colour of your hair, are you busy?”
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US CPI Print: https://www.bls.gov/news.release/pdf/cpi.pdf
Bank of England, MPC: https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/august-2023
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