Fed Pivot Excitement Needs A Rethink

November 18, 2022

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Meanwhile a profits recession is highly likely for early 2023.

The disease of our times is that we live on the surface. We’re a mile wide and an inch deep.”
Steven Pressfield

The world is on the path to hyperinflation
Paul Singer, Elliott Management

After the slightly lower than expected CPI reading last week, the S&P500 had its biggest one day CPI reaction since 1949. The panic buying, also reflected in the options market, was based on the assumption that the data would accelerate the end of Fed tightening, which in turn led to the additional assumption that it was therefore time to buy equities.

This thought process is not historically well founded. The record shows that a pivot has often been a better sell signal! There is a much more reliable economic and equity indicator which has strengthened in the opposite direction.

The chart below shows that on at least five occasions when a pivot actually happened, it was at the beginning of an equity collapse. Think again.

In the 1970s interest rates were twice cut too early, and then subsequently had to be raised to even higher levels. If equities do rally on an interest rate cut it may well be a signal that the interest rate cut is too early.

Fed Chair Powell is aware of this and has been very clear since the August Jackson Hole meeting that Fed tightening still has some way to go. He articulated that there are three stages to a pivot and we may only be entering the first of those stages. He has even stated that Treasury yields need to be above inflation and currently Fed funds are 3% below the CPI even if it is now declining. The pivot will take time and how much does it matter?

Historically economic cycles much more closely align with the equity performance outlook than interest rate policy. By far the most successful indicator of a deep recession and a major equity bear market has been the yield curve. The chart below shows the perfect record of the yield curve in recent decades not just for recessions but also the equity market.

“The US Treasury curve is now more than 70% inverted.  In the last 50 years of history, every time we have surpassed this threshold a recession followed. We are now at 76% with the Fed still hiking rates and doing QT.”
Tavi Costa

The issue is therefore more complex than when a pivot happens. Different parts of the economy have different levels and rates of change in there own cycles. Some key components have not turned sufficiently.

The chart below shows that the labor market has not even showed any real uptick in jobless claims, which must be a necessary condition for tightening, even if it is a lagging indicator. The strength of labor may well be distorted by a declining working age population, but whatever the cause, a tight jobs market gives no assurance that wage inflation is contained.

The massive COVID-19 stimulus is taking time to dissipate. Balance sheets across the economy were boosted as never before. Credit card and “other” balances reached multi decade lows. This is now changing at a rapid rate but the level of debt is still below pre COVID-19 levels.

However, corporate earnings are already seeing a significant decline and an earnings recession seems likely in 2023.

The outlook for earnings on the indicator below is worse than the last two major recessions.

The margin decline could be severe into the first half of 2023 as shown below.

Buybacks, continue to distort the US equity market, and corporate managers have learnt that shareholders are more rewarded by buybacks than capex and R&D investment or mergers and acquisitions.

Buybacks will continue to support equities and make another record in 2022 but to some extent QT will likely be some kind of offset for markets overall.

Summary

Check you premise and question short term market behavior. The pivot obsession seems to be a temporary market factor. Guessing the timing of the interest rate pivot on each data point is not your best investment indicator. Focus on the cycle data, Fed Chair Powell, and the yield curve, not pivot excitement.

This is a complex set of conditions that is a challenge for all investors. If there was any doubt about this then read the latest thoughts of a 45 year veteran investor, and one of the 5 top Best Investors on my list, Paul Singer.

Transform Your Investment Experience

The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs Best Investor metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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