In addition to the hot January PCE print, the other surprise of last week was the upbeat flash PMI from S&P Global Market Intelligence
(formerly IHS Markit) showing upside surprises from the G4 industrialized countries. Increasingly, the market narrative is shifting from a growth slowdown to no recession and continued growth. The markets are behaving the same way, as they turn to discounting a growth revival, led by a successful China reopening.
At the same time, last week’s release of the February FOMC minutes
warned, “Participants observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2%, which was likely to take some time.”
What should you do? Fight the tape, or fight the Fed?
Hard, soft, or no landing?
Ever since the Federal Reserve began to tighten monetary policy and show its determination to bring inflation back to its 2% target, economists and strategists have debated whether the US economy would experience a hard landing, soft landing, or, more recently, no landing.
First, let’s define some terms. The chart below shows the history of the US unemployment rate with peaks and valleys labelled (blue line), core inflation (red line), and recession periods shaded. We would define a hard landing as a recessionary period when the unemployment rate rose more than 3% and soft landings otherwise. The 1990 and the 2000-2002 periods qualify as soft landings, though unemployment rose further after the recession ended. The 2022 COVID Crash would have been the hardest landing comparable to the Great Depression were it not for the unprecedented level of fiscal and monetary response by Congress and the Federal Reserve.
A no-landing scenario implies that unemployment doesn’t rise much, growth doesn’t decline much, but inflation remains elevated. Increasingly, market action is shifting towards that view as cyclical industries with the exception of oil and gas are outperforming the market. The recent results of the BoA Global Fund Manager Survey showed recession fears peaked in November 2022 and have fallen sharply.
The current economic cycle is somewhat unusual compared to past cycles. Manufacturing and goods inflation have weakened, but services inflation remains strong. In particular, the labor market is tight and unemployment is low, as Fed Chair Powell pointed out in his February post-FOMC press conference
However, US economic growth is beating expectations. The January Jobs Report saw half a million new jobs, retail sales grow a whopping 3%, and the January stronger-than-expected PCE report are all supportive of the no-landing narrative. However, a no-landing growth pattern where inflation remains elevated will force the Fed to raise rates even further, which risks an eventual hard landing.
Current market expectations calls for three more consecutive quarter-point rate hikes, followed by a plateau and no rate cut in late 2023. With the caveat that the last FOMC occurred before the blockbuster January Jobs Report and strong retail sales print, the minutes showed that “almost all” participants agreed to a 25 basis point rate hike, and only “a few participants stated that they favored raising the target range for the federal funds rate 50 basis points at this meeting or that they could have supported raising the target by that amount”. In a victory for the doves, it seems that Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard, who called for a 50 basis point hike at the next meeting, have little support within the FOMC.
Recession to the left, recession to the right
Despite the rosy numbers, forward looking indicators point to a recession ahead. New Deal democrat
, who maintains a set of coincident, short-leading, and long-leading economic indicators with zero, six, and 12 month time horizons respectively, believes the economy is on the verge of entering a recession, but positive developments in leading indicators point to better times ahead.
There are two trends percolating under the surface. One trend is the continued slow decaying of growth in the coincident indicators. The other is the slow move towards turning neutral or positive among some of the long and even short leading indicators.
No forecast at this point, but I am beginning to suspect that, while there will be a recession, it will be relatively short and relatively mild.
Unrelated to any of New Deal democrat’s analysis, the results of the quarterly loan officer’s survey is disturbing inasmuch as it’s signaling a credit crunch. A net 44.8% of banks are tightening credit for large and middle-market firms and the results for small-market firms, which are not shown, are similar. While the history for this series is limited, readings above 40% have either led to, or coincided, with a recession.
Even if the economy were to avoid a recession, continued growth and elevated inflation are likely to see the Fed react with even a tighter monetary policy and higher interest rates. Such a scenario is reminiscent of the double-dip recession of 1980-1982, when the Volcker Fed initially cut rates in 1980, only to raise them again to very painful levels until something broke. In this case, it was the Mexican Peso Crisis that threatened the solvency of the US banking system.
What’s holding up the market?
In light of the dubious macro outlook, what’s holding up the market. Marketwatch
reported that Morgan Stanley’s Mike Wilson pointed to rising liquidity as an explanation for the risk-on character of the market, and compared the current situation to climbers on Mount Everest.
Either by choice or out of necessity investors have followed stock prices to dizzying heights once again as liquidity (bottled oxygen) allows them to climb into a region where they know they shouldn’t go and cannot live very long. They climb in pursuit of the ultimate topping out of greed, assuming they will be able to descend without catastrophic consequences. But the oxygen eventually runs out and those who ignore the risks get hurt.
Wilson went on to warn about the elevated valuation of the stock market. Indeed, the S&P 500 forward P/E is exhibiting a strong negative divergence compared to the 10-year real rate.
On the other hand, Fed liquidity has been fairly stable despite the Fed’s quantitative tightening program. That’s because the Treasury Department is drawing down the Treasury General Account (TGA) held at the Fed and supplying the banking system with liquidity as part of its “extraordinary measures” to mitigate the effects of the debt ceiling. Treasury Secretary Janet Yellen has estimated that the government will run out of money in June, while the Congressional Budget Office’s estimate is between July and September.
From a global perspective, FT Alphaville
reported that Apollo chief economist Torsten Sløk pointed out that the BoJ’s liquidity injections as part of its yield curve control program is overwhelming the Fed’s QT.
That’s not all. The PBoC is another major supplier of liquidity to the global financial system (see Fed paper What Happens in China Does Not Stay in China
). Recent evidence shows that the PBoC has been ramping up liquidity, which has the effect of holding up the price of risky assets.
In light of these cross-currents, what should investors do? Should they fight the tape, or fight the Fed, along with elevated valuation risk?
I believe that the answer lies with investment time horizon. In the short run, liquidity controls the tape. In the long run, valuation and interest rates matter to returns. For now, European stock and cyclical industries are the leadership. Enjoy the ride and take shelter if their leadership falters.
Party now, pay later.