With a nod to one of America’s most famous poets, Ralph Waldo Emerson, today’s title seems quite apropos given last week’s market action, states Jay Pelosky of TPW Advisory.
Everyone seems to know the destination: decent global growth, job creation, and "lowflation", but there is next to no consensus on how to get there.
There are at least two clear-cut camps at opposite ends of the spectrum. One is the "inflationistas", Deutsche Bank, and others who fear continued high inflation and believe the Fed needs to tighten even more aggressively than the markets have priced in. The other camp includes our good buddy Chase at Pinecone Macro, who sees growth slowing fast and fears a Fed policy mistake by hiking into a slowdown that’s already underway.
Identifying these two camps helps one understand the post-Fed meet market action Wednesday and Thursday's abrupt and almost jaw-dropping cross-asset reversal. As expected, the Fed hiked 50 bps; in the first in-person press conf in over two years, Chair Powell was then asked about prospects for an upcoming 75 bp hike—something the inflation camp thinks is needed. He indicated that such was not currently being considered, setting equity markets off on a 3% + rally as the growth worry camp took the policy mistake risk off the table.
Friday's markets were milling around until the Q1 labor cost and productivity numbers came out, and they were a terrible twosome. Labor costs well above expectations, thus spooking the inflation camp and very bad, horrible productivity numbers, reinforcing the growth camp concerns around earnings and margins. Thus, a dramatic cross-asset selloff ensued, reinforcing the unusually wide negativity that is starting to characterize the current environment.
This is the type of febrile, complex market that shoots first and asks questions later. Here is a more reasoned take from Pantheon Macro, a group that has a pretty good handle on things economic: "The productivity and costs numbers are always volatile but they have been wild since Covid struck, so the noise in each quarterly print overwhelms the signal. In Q2, we expect output to rebound strongly and hiring to slow, so productivity will jump and unit labor costs will either slow or fall outright. We look for 2%-productivity growth over the next few years. That will help push inflation back to the target, and sustainably boost real incomes and corporate earnings. It will also raise the neutral real interest rate; nothing is free, after all."
Here is Pantheon on the April job numbers: "We know from the NFIB survey’s measure of hiring intentions that firms have been gradually scaling back their plans since the peak last August, and that the invasion of Ukraine then triggered a further step-down. The index has been little changed since its February drop, though, and is now broadly consistent with job gains trending at about 250K. It’s hard to see hiring intentions changing unless oil prices drop sharply, and that seems an unlikely near-term prospect.
Sustained job gains of 250K per month would, by normal standards, be very strong. The three-month annualized rate of increase of AHE now stands at just 3.7%, the lowest since March 2021, and down sharply from 6.3% as recently as November last year. The rising trend in participation appears to be facilitating a moderation in wage growth, but nothing is certain until the mix-adjusted quarterly ECI data tell the same story."
What does TPW Advisory think about all this? Is it maintaining its constructive outlook, both tactical (coming few months/Qs) and strategic (next one to three years)? Well, our monthly Model Portfolio updating process took place this week following last week’s publication of our Monthly “Confusion by Extrapolation” and the answer is yes, we remain constructive and believe in our inflation “Fever Break” thesis espoused a few weeks ago. We are heartened by Pantheon’s comments on productivity growth as that remains a key plank to our BTE growth/low inflation medium-term thesis for the 2023-2025 time frame.
Perhaps it will not come as a surprise to note we think there is a different near-term path than either high inflation or weak growth: a middle, more moderate path where inflation rolls over (becoming evident in the data) likely as early as next week’s April CPI print while growth remains intact as the economy shifts from goods demand-driven to services supply-driven, especially in the DM economies of US, EU, and Japan. Along this path, inflation moderates to 4% or so by YE, allowing the Fed time to breathe and execute its policy of attacking sticky inflation without “breaking something”. Citadel’s CEO Ken Griffin is a fan of this path if that gives it more credence.
Our former MS colleague Stephen Jen of Eurizon lays it out like this: current US 8% inflation can be broken into two parts, sticky and flexible, with sticky at 3% and flexible at 5%. Flexible is rolling off as Covid ebbs, supply chains and energy prices stabilize, wage gains moderate, etc. This allows the Fed to focus on the sticky inflation via a steady diet of rate hikes and QT as already embraced and priced into markets. A terminal FFR of around 3%, the two-year UST at 2.7%, and the ten-year now above 3% suggests a real rate around zero, implying that the Fed is not as far behind the curve as the inflation bears fear.
It's clear that as the debt to GDP ratio expands, the peak policy rate has come in significantly. A modest real rate could well be enough to cool inflation as Fed jawboning (look at mortgage rates and housing) and actual rate hikes cool off demand, especially on the labor side where there are roughly two vacancies for every aspiring worker, thus risking a wage-price spiral (of which there is no sign currently as noted by the AHE data above).
We continue to think investors are struggling to grasp the impact and importance of a high nominal growth environment and what it means for sales and earnings. Q1 earnings provide an illustration—while US Q1 GDP came in quite weak, again distorted by economic cross currents and likely to be reversed in the current Q, Q1 EPS are coming in BTE expected across the DM with both sales and profit growth in positive surprise territory. Given that DM nominal growth is running around 6-8% vs pre Covid 3-4% it makes sense that EPS are beating and notwithstanding all the gnashing of teeth and equity weakness Q1 EPS estimates are being revised up, not down, and future Qs are likewise being revised up, not down.
A main support for our continued constructive outlook and subsequent positioning is because we see the 2022 DM consensus single-digit EPS expectations as easy to beat. The credit puppy that has refused to bark and the low real rate are two other key factors keeping us constructive. One can pick up any paper, podcast, or tweet for examples of historic bearishness and light positioning with my current favorite being the record buying of inverse ETFs.
There is of course so much more to discuss: Europe’s Russian oil embargo (energy prices seem pretty stable), Russia’s weakness on the battlefield (will Putin sue for peace as the Ukraine takes the offensive), Japanese yen doom loop fears (inflation is a plus for Japan and Japan, Inc. will print money at current $/Y rates) not to mention China’s Zero Covid, anti Xi rumblings and the way-too-long wait for actual policy support in China.
We note these to let you know we are on them and happy to discuss them. It’s a time to be humble and stay flexible. The current investment environment tends to lead to either investor paralysis or capitulation. We don’t think either makes sense and remain focused on our investment process, which leads us to make limited model portfolio changes this month. We note that many of our major themes are playing out: ROW equity OP vs the US, US Big Cap Tech UP, Small Caps OP LC, Value OP Growth, Bond Bear market, Commodity Bull market, etc. These reinforce our decision to remain positioned as we are.
While we agree with Chair Powell that in today’s environment it is extremely difficult to provide forward guidance for even 60-90 days, we do expect a significant reversal in inflation over the coming months that should lead to a tactical rally in rates, a rally in high beta thematics, a USD rollover, and a boost to cyclical and value segments of stock markets. Several of the geopolitical issues noted above may also be ripe for turning, providing support for our non US equity OW.