Market Update November 2022 – This Time It’s Different?
CAPITAL MARKETS
“This time it’s different” Dangerous words! Global markets have rebelled when hearing this phrase and investors have learned the hard way that using it is to proceed at your own risk. But, could it actually be true in 2022?
Starting with the demise of the “dot-com” period and following through to the COVID pandemic, monetary officials have fought a common challenge during the 21st century. Generally, capital markets were stressed by slowing economic conditions, era’s such as the “housing bubble”, European Sovereign debt concerns, “Brexit” and the COVID pandemic. The common threat throughout these crises was damage to global economic conditions. And, most often, the prescription was “stimulus” in all its different forms.
Today, central banks are fighting a different issue. Rather than addressing a faltering economy requiring monetary authorities’ support to combat recession, the battle today (as strange as it might seem) is to cool down an economy deemed to be too strong. Whether the culprit is strong demand on the back of fiscal and monetary policies, or due to global challenges impacting supply, the imbalance between supply and demand has caused prices to surge. Quite nearly the opposite of what investors have experienced for much of the past twenty years.
Does this distinction between different periods of economic stress matter? Comparing today’s conditions with those going back to 2000 is akin to a slowing car. Is it running out of gas? Or slowing after exceeding the speed limit? In past years, the economy had been running out of gas and the Central Bank “gas station” discounted prices (i.e., declining interest rates), allowing drivers to replenish their tanks more easily. Today, the economic car has gas in the tank, but is running over the “speed limit” and must slowdown for everyone’s safety.
Yes, this oversimplifies the analogy comparing slowing economic eras of the past twenty-plus years to that of the economic-cooling of today. But more importantly than the comparison is the outcome. Following the post-COVID stimulus, too much “gasoline” is still in the tank, risking the danger of the economy continuing to drive well above the speed limit – a set up for an accident.
Analogy aside, the economic focus is on inflation and (1) the risk it may bring to economic health (2) when might it slow down and (3) its impact on interest rates. In the “speeding car” scenario the Federal Reserve’s objective is to slow the post-COVID stimulus effect and contain inflation. If unconstrained, cost of goods and services may spiral higher as supply is limited and sold to the highest bidders. Should Central Banks see prices rising at a concerning pace, they are likely to use their primary tool of interest rate management to combat inflation. By raising benchmark interest rates (i.e., raise the cost money) it would be expected that demand would slow which, in turn, would also dampen inflationary pressures. As is often the case, global Central Banks have found themselves late to the game and have had to play catchup through larger rate hikes than we’ve seen for quite some time. But now, we may be starting to see signs of potential progress.
The Consumer Price Index (CPI) is the most widely watched gauge of inflation measuring “the average change over time of prices paid by urban consumers for a market basket of consumer goods and services”. While not perfect, CPI does convey the state of price pressures. The Bloomberg Intelligence chart below examines the relationship of various inflation-related items. While the description below is somewhat technical, in summary, the chart looks at current conditions, market pricing and seasonal tendencies to construct a potential path for receding inflation. After peaking in June 2022 at 9.1%, CPI receded to 8.2% in September 2022 and is expected to trend lower by year-end. While the chart takes CPI down much further into mid-2023, the broader take-away is not the specific levels, but that markets are gradually seeing potential directional paths to receding inflation over the coming months. And we’ll hope there’s still gas in the tank.
Inflation Heading Lower If Market Pricing Realized Scenarios for Year-Over-Year CPI
The inflation-swap market is pricing for the consumer price index to end 2022 at 7.1% year-over-year and to decline to a 3% rate by June. However, if we use the average seasonal run-rate between 2015-19 for the months between October 2022 and June 2023– headline CPI would decline to 2%. In either case, the fed funds rate deflated by year-over-year headline CPI would turn positive in 1Q or early 2Q. If the real funds rate does turn positive, the Federal Reserve will plausibly note monetary policy is in restrictive territory. A larger but decreasing PCE-wedge may mean an ever more positive real rate using that measure.
Monthly inflation could be a more important gauge of the current policy stance. The Fed will likely want to see a positive policy rate when adjusted by month-over-month and quarter-on-quarter inflation as well.
Source: SDR, Bloomberg Intelligence, 10/26/22
JAMES FERRIN
Chief Investment Officer
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