“When the light begins to change…”
Fear of the Dark, Iron Maiden
The dominant market narrative at the moment is centred around the debate over one question - will, (or won’t) the Central Bank-induced tightening of financial conditions (as a response to rampant inflation) tip respective economies into recession. Over recent weeks, this debate has pivoted between an emphasis on inflation and an emphasis of recession, or growth fears. However, none of the debate has focussed on what that recession may look like, if indeed there is one.
Last week, we discussed the June Federal Open Market Committee (FOMC) meeting and the motivation behind the new hawkish acceleration. “It was clear that the Fed had one intention above all in June - to regain its credibility in relation to its inflation mandate, or to regain control of the inflation narrative from the market.” However, we also noted that “It is possible that in attempting to regain control of the inflation narrative (with a more hawkish, front loaded monetary reaction function) that Fed shifts the market concern to growth from inflation.”
This week, we have seen that shift in action, as the US rate curve has priced out some of the tightening, with the curve remaining very flat. By traditional inference, this suggests that markets are implying very low rates of real economic growth over the period. However, this inference does not, in our view, take into account the distortion of bond markets at the hands of unparalleled QE, and indeed the prospects of its reverse, QT. Are markets being too pessimistic?
I have seen analysis this week that suggest that the average equity price decline from either event-driven or cyclical recessions is in the order of magnitude of 30%, with a range of values for both the pace of the decline and subsequent rebound. Well, equity markets have already corrected by broadly 30% across the globe, yet data suggests that there is a very significant equity short position (on some measures the most significant since the 2008 global financial crisis).
Inflation, and in the UK the proliferation of strike action, have given rise to a lot of comparisons to the 70’s; but so far at least, inflation today is lower and less entrenched. Further, recent commodity price trends show some reduction of pressure, not just from the industrial metals and even oil, but also wheat other soft commodities. There is a risk of a more pernicious inflation problem across the globe - most notably in the UK perhaps - but it still likely remains a tail risk.
On the employment front, data suggests that even mild recessions have resulted in a rise in the unemployment rate of 2 percentage points, and many are calling for much worse. Indeed, it is clear from this week’s, Chair of the Federal Reserve’s testimony that the labour market is the battleground for the Federal Reserve System’s (Fed’s) battle against inflation. However, there still remain a record number of unfilled jobs in the US, and this excess demand for labour likely acts as the first line of defence against a significant rise in the jobless rate.
This week, in his semi-annual testimony to Congress, Fed Chair (in answer to numerous and often politically motivated questions) gave further communication on the current Fed stance, its economic viewpoint, and the prospective Fed rate path. The narrative was largely consistent with the June FOMC statement and press conference - hardly surprising, given that it was only last week!
However, there has subsequently been some debate as to whether Fed’s Chair vocabulary and intimation around the prospect of a US recession signalled a deterioration. My view is that there is a difference between the vocabulary and inference built into a very carefully thought out and reviewed Statement (and even press conference) and the responses to some at times hostile questioning, and whereby the answers are aimed more at ‘Main Street’ than ‘Wall Street’ - as per the majority of the FOMC communications.
Chair of the Fed began his testimony with the explicit statement that “the US economy is very strong and can handle tighter policy” with “an inflation that is more about demand than other countries”. Indeed, Fed Chair stated clearly the Fed view that the consumer sector “is in very strong shape financially”. President and CEO of the Federal Reserve Bank of Richmond (a non-voting member this year) also stated that the current household and business balance sheets are “healthy” and “being supported”, further stating that supply chains seem to be improving. However, Chair of the Fed was also clear that while “there is really not anything the Fed can do about oil prices” and that Fed hikes “likely won’t bring down food prices”, it does aim to get the labour market back in balance - adding there are already signs that job growth is starting to slow to a more sustainable level and wages growth has been moderating for a number of months now.
This week’s market emphasis change - back towards growth from inflation - was in part due to the communication and messaging of the FOMC pivot (to 75bps) - regaining control of the inflation narrative - and thus reducing the tail risk scenario of a later, more aggressive inflation and Fed catch up, BUT also in part due to the implications of the latest hawkish acceleration of the Fed and the uncertain implications of the front-loaded tightening on household and corporate expenditure. We remain more glass half full than the market and feel that the US consumer and more specifically corporate balance sheets and prospective forward earnings likely hold in better than current equity price action and positioning suggests.
The key fact in my mind is still that private balance sheets, both on the household and corporate side, remain strong. At the consumer level, recent strong job and wage growth add to the pandemic savings buffer and Corporate America has a very strong balance sheet - one where overall leverage is low and there are very low refinancing needs within the next two years. Labour markets will be the battleground for the Fed’s inflation fight, but the excess demand for labour should soften the blow.
The global economy remains a very uncertain place, with many moving parts; and financial markets have offered very low Sharpe Ratio this year. However, while sentiment appears to be turning more negative at current levels, we retain a more positive outlook. The key to this discrepancy may be that the prospective ‘recession’ that markets fear is poorly defined. A technical recession, where two quarters register a negative print (even if the year on year data remains positive) is a far cry from the fallout from the global financial crisis!
Lastly, last week we touched on the implications of last weeks Fed on risk assets and EMFX.
Developed Market (DM) Central Bank rate hikes are now much more fully priced, outside of the prospect of more ingrained second round effects and a de-anchoring of inflation expectations; and the Fed has regained control of the inflation narrative (as we discussed at greater length last week). It could therefore be argued that there is lower interest rate vol (or at least future implied rate vol) as a result, as the front-loaded Fed tightening narrows the potential path for terminal interest rates, against a more pernicious - unanchored inflation.
Further, if we add the fact that this is now to a greater extent also represented across the DM world - with the ECB, BoE, BoC, Scandis and even SNB (all bar the BoJ) - then we can likely expect lower spread vol or lower movements in DM rate differentials - especially as monetary policy is targeting a common, and largely coordinated threat: inflation. By extension, this implies lower currency volatility.
If we add these factors together, narrower terminal rate expectation distributions in DM, lower rate, spread and currency vol, then the prospects for EMFX in the near term, specifically those that offer significant carry (MXN, BRL, and even ZAR), or carry to vol (INR) appear much more rosy! Indeed, to paraphrase Iron Maiden, perhaps the light is beginning to change and we shouldn’t be so afraid of the dark?
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FOMC Meeting, June 2022 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220615.htm
Semiannual Monetary Policy Report to the Congress 22, June 2022 - https://www.federalreserve.gov/newsevents/testimony/powell20220622a.htm
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