“Following the path as it leads towards the darkness in the north“
Pink Floyd, The Narrow Way
Last week, we discussed the most recent iteration of US monetary policy following the November FOMC where they left rates unchanged at 5.25-5.50% as expected. The statement added the term ‘financial’ to the opening statement, such that it now reads “Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation”. Thus we argued that we see this as a further confirmation of our view that the Fed hiking cycle is over, and also a recognition that the sell-off in US duration is likely to cause a significant tightening of financial conditions that the Fed have become more attentive to - “tighter financial conditions we are seeing from long-term rates and also from other sources like the stronger dollar and lower equity prices could matter for future rate decisions”.
Further, we argued that the Chair of the Fed was very clear in the press conference that while the economy has been surprising in its resilience, there are “many forecasters forecasting it will slow” and that “the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” The data is thus key. However, we expect the US economy to slow significantly from the Q3 pace. Last week we also highlighted the potential importance of the Atlanta Fed Nowcast update that showed its Q4 projection at just 1.2% (below most measures of equilibrium growth and thus an environment where demand is insufficient to drive above target inflation).
Lastly, by extension, we made the argument that Q3 likely marks the point of peak global growth divergence as the negative impulse from the slowing Chinese economy (and by extension European) is arrested by piecemeal, targeted stimulus measures - and the most recent, significant, fiscal expansion. And, as European inflation continues to decline, domestic demand is supported by rising real incomes. At the same time the US economy slows back to below potential.
While this week, the Atlanta Fed Nowcast has been revised back slightly higher (to 2.1% q/q annualised), this is still a significant step down from the near 5% pace of Q3 and we expect more focus on the weakening growth impulse in the US to dominate sentiment into year-end and beyond, with logical implications for US rates, risk assets and the USD (with risk assets being supported in the first instance by lower rates).
While this week has been quiet from a data perspective (the dominant near-term data focus will be the October US CPI and Retail Sales next week - with specific inference to the impact of the resumption of student debt repayments as of October), from a US rate policy perspective, there have been a number of Fed speakers this week including the Fed’s Chair. From our perspective, there is a further consolidation of the (albeit relatively slow and careful) change in stance from the Fed. Essentially, the Fed appears to be increasingly comfortable that the current policy settings are ‘sufficiently restrictive’ and thus having the desired effect of bringing inflation back to target - even if they remain uncomfortable in offering any prescriptive forward guidance.
At the November FOMC the Fed’s Chair stated that above-trend growth on its own was not sufficient in its own right to warrant higher rates - he continued to play down the concept of a mechanical relationship between higher growth and higher rates at the IMF this week and while the reports of his speech led with the headline that the Fed “will not hesitate to move more [on rates] if appropriate”, the tone of the speech was more conciliatory in terms of forward-looking growth expectations - “imbalances easing from the tight labor market” and that the Fed will “move carefully to avoid the risk of overtightening”. Indeed others stressed clearer signs of weakness in growth - Richmond Fed Barkin said that “anecdotal evidence is at odds with the latest [strong] GDP report” and that he expects previous hikes “will eventually hit the economy harder”.
In corroboration with the evolving caution towards growth projections, as the US Q3 earnings season reaches a close, there have been some notable themes in this regard. Firstly, with 80% of S&P 500 firms having reported, less than half have beaten revenue estimates for Q3 and the pace of sales growth has also moderated - Despite the fact that Earnings have continued to surprise to the topside. Furthermore, “weak demand” was among the top trending phrases in the US earnings calls, with near-record mentions in the Q3 reporting season.
We don’t expect a recessionary backdrop to evolve in the US (at least in the near term), but the rebalancing of supply and demand is likely to have notable implications for global rebalancing (or the correction of global growth divergence in favour of the US that we witnessed in Q3), for bonds, equities, and the USD. We expect this to be an increasingly apparent theme through Q4.
To Paraphrase Pink Floyd the Fed narrative appears to be following a path that leads towards weaker growth and while the Fed will be focussed on the ‘Narrow Way’ or soft landing in the US, Markets are increasingly likely in Q4 to focus on the narrowing of global growth differentials from our perspective.
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Bank of England, November 2023 - https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/november-2023
FOMC, October 31. 2023 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20231101.htm
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