In our last Markets in Motion, we discussed that the Fed is unlikely to pivot from their aggressive monetary tightening. Since then, Fed speakers have reiterated that stance. Another theme is that inflation actually needs to come down before the FOMC will be willing to accept a change of course: as Fed Governor Waller noted “we have not made meaningful progress yet on inflation.” This drumbeat of hawkishness helped push two-year yields to the highest levels of the cycle, drove a renewed dollar advance, knee -capped stocks, and sent credit spreads sharply wider. Simply put, the FOMC wants even tighter financial conditions as a way to restrict economic growth. While Fed tightening has not yet brought down inflation, financial conditions have undoubtedly tightened, and are now the least supportive of growth in a decade with two exceptions (2015 and the COVID crash). (Chart 1) Until CPI/PPI/PCE starts to come down, the FOMC says it will not reverse its course. Markets, which are already having one of their worst years in history, remain at risk from more Fed damage.
So lets assess the damage…
As fears mount for the growth outlook around the world, economic momentum continues to fade. The US leading economic indcator has been contracting year-over-year for three months and is now consitent with heigntened recession risk. Addtionally, the 10-year treasury yield just inverted below the 3-month yield – historically a very accurate harbinger for recession. While the labor market remains strong (which isnt helping inflation), the question seems to be not if but when we see a recession. The Fed has a poor history of achieving soft landings and its plan to reduce job openings and raise the unemployment rate without sparking a contraction will be hard to execute. Most of the Fed’s target indicators like job openings, wages and trailing inflation are coincidental, or lagging. (Chart 2) Hence, by the time the Fed declares “mission accomplished”, there is a good chance that the US economy will already be contracting substantially.
By targeting coincidental or lagging indicators, the Fed is setting itself up to overtighten. Powell has already prepared the ground with his argument that any upcoming economic pain is a lesser price to pay than accepting persistently high inflation. Therefore, the Fed can probably get away with engineering a recession on a lesser-of-two-evils basis. (Chart 3)
Hence, resolute Fed hawkishness keeps us cautious. Uncertainty remains high with cross-asset volatility the highest it’s been since the Great Financial Crisis. In addition, Fed hikes will only make cash more attractive. Money market funds have closely tracked the Fed Funds rate over the past two decades.
Over the last couple years, we’ve discussed the high probability for regime change in markets that will benefit tactical management. Two decades of low growth, low inflation, low interest rates, and low bond yields created $70 trillion of growth stocks and government bonds priced for that minimal growth regime. The last two decades were likely an aberration, not the new normal, and we see scope for higher neutral rates. Regime change happens in fits and starts, but we believe it’s the end of the dominant run for passive investing and the long duration assets that make up typical 60/40 portfolios.
Over the past few months, we have made defensive moves to cash & equivalents in our underlying funds. Our main asset allocation views continue to hold cash & barbell that exposure with equities. Markets do not bottom on good news and a lot of damage has already been done. While we remain cautious in the near-term, we anticipate a lot of opportunities in the next 6-12 months.
Recent Portfolio Changes
There have been no changes to the portfolio positioning since July 19, 2022.
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John A. Forlines III
Chief Investment Officer
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