Investors are falling over themselves to price in an ever more aggressive, faster, bigger rate tightening cycle, states Jay Pelosky of TPW Advisory.
Of course, I must be joking with my title right? I mean it’s the Fed all day every day, minus a few break-ins from the Russia–Ukraine border.
But could all this attention mean, after multiple false summits, that we have finally seen “peak Fed hawkishness”? I noted my poor attempts to time such an event last week, but I think we might have finally done it.
Like the high mountain peaks, these Fed peaks are often only obvious in the rear-view mirror. I note then that several weeks ago markets were pricing in an 80-90% likelihood of a 50 bp March rate hike to start us off…those odds are now down to between 30-40%. Still possible and I note that Steve Blitz of Lombard, someone I respect, believes the Fed will do exactly that, but the market seems to have swung the other way. Peak Fed hawkishness seems to be behind us. As Chase Taylor of Pinecone Macro says: Extrapolation=Opportunity.
It’s 2022 though, and the new rules say the S&P 500 ETF Trust (SPY) can’t start and finish the same day in the green (believe its only happened once ytd), so enter the Ukraine to do a tag team on the indices… if there is one thing more inscrutable than the Fed, it's Russian President Putin. The back and forth headlines over the past few days between US saying war is imminent and the Kremlin saying we don’t want a war, have been particularly hard to read. My International Affairs MA has been of limited use, though my positioning says I don’t expect a full scale invasion. Jaw Jaw remains better than war war.
So what would a post Fed world look like? I think this is the question investors need to ponder given that markets have effectively priced in six-seven rate hikes this year and it's highly unlikely the Fed will be more aggressive than this (my guess remains two or three rate hikes). Even JPM and Morgan Stanley have jumped on the six or seven rate hike train…as a former MS strategist, I can just envision the research meetings with the poor economists getting beaten over the head about how obvious it is the Fed is gonna raise and keep raising till something breaks. Its hard to resist that internal pressure even if it means as in the GS case that economics say seven rate hikes and equity strategy says 10% upside in SPY thru YE.
That line—the Fed needs to bring inflation down and will hike until something breaks (read equity market) represents the bear case. It seems straightforward and simple enough but I wonder if its not too simple.
The Fed clearly doesn’t want to break something—this is not a hawkish Fed (minus Mr. Bullard of course, which is perhaps why he has to pound his POV until the cows come home). It is a Fed that has changed its approach to FAIT (or is it FATE) and so has provided itself with some leeway, to be data dependent. Of course no one foresaw 7-8% inflation when this change was made, but its unlikely the Fed will want to give up its hard won flexibility at the first major challenge. If the Fed’s choice is to drive inflation back to 2% but break things in the process, or bring it to 3% and declare a breakage free victory, I expect it to choose the latter path.
The media is full of stories about how Fed has lost control, yet the longer term fixed income market says nothing of the sort—in fact, if you look at three and five year inflation forwards, the market is judging that the Fed has things well in hand and will be successful in bringing inflation back to the 3% range. The timing of the cycle has been sped up and yield curve flattening has already happened to a large extent; we may be seeing something like the aggressive Fed tightening cycle of 1994 play out before the Fed does a thing. Back then, the spread between the two year and FFR peaked at roughly 200 bps, which also marked the low for equities. Today, before the Fed has raised even once, that spread is roughly 150 bps.
I am excited to finally see some push back to the idea the Fed has to tighten until things break. The Economist recently published an editorial making this point and Conor Sen of Bloomberg has done the same, noting the potential for “boomflation,” as I wrote last week. I agree with this view and expect we are moving to a higher growth plane, above the 2.3% real av that prevailed in the US between 2015-19. This would prove to be a positive surprise to investors who are pricing in a return to that growth path.
Boomflation is likely to be driven by a strong global consumer, surging cap ex, global climate mitigation spending, and rising productivity as the multiple technologies that enjoyed accelerated adoption during Covid become more visible as Covid itself moves from pandemic to endemic. The result will be higher nominal growth, maybe 5-7% in the US vs 3-4% pre Covid, split between 3% real growth and 3% inflation. MS for example expects 9% nominal US growth this year. Such growth would suggest solid earnings growth as well.
This higher growth path will sustain the asset allocation changes already in train: within Equity, from Growth to Value, from US to non US leadership—at a time of record foreign ownership of US equity; in FI, a DM sovereign bond bear market (now underway ex China) and a Commodity bull market. The surprise will be not that these moves revert but that they are sustained for the next several years.
This post Fed period will start to unfold soon—2023 is the out year and soon enough 2024 will come into play as we exit pandemic Covid and focus forward. I see the 2022-2025 period as akin to the 2nd half of the 1990s—the 1995-1999 period which represented the last period of US cap ex boom and productivity surge. This time it will be global, reinforcing the policy set up for non US equity. There are market similarities as well—the last time the SPY and AGG had coincident 5% drawdowns from highs as it has now was in 1994.
The near term tactical outlook seems pretty clear to me as described in last week’s Musings, as does the strategic outlook noted above. It’s the middle—the handoff that needs some more thinking, as I noted in several recent client calls. This is where I plan to spend my time in the coming weeks and months, fleshing out the handoff from tactical to strategic as we move thru 2022.
From a market POV, the area of focus is on thematics and the timing to re-enter the ARK Innovation ETF (ARKK) type disruptive tech space. Fundamentals, technical analysis, and valuation will all play a role in the process. The public–private market interplay will also be important—private equity has tons of dry powder and could underpin post capitulation valuations in this space. Crescat Capital notes that the Venture Capital index has already fallen 40% from its peak. Cross over buyers are swinging back into the cheaper (in some cases much cheaper) public markets.
Our recent model portfolio decisions: to add to our Cyclical holdings, gold miners and Brazil in our Global Multi Asset (GMA) model portfolio and put cash to work in our TPW 20 Thematic model are playing out well so far. We are not yet out of the woods and a retest is always possible; but with the Fed priced in, strong Q4 EPS across US, EU, Japan, sentiment as bad (read good) as it has been in several years, much cleaner positioning (record short position in ARKK) and LTE inflation (two year rallying) and BTE growth ahead (January retail sales, GS lockdown index falling), it feels right to be thinking opportunistically.
