April 2022 - Monthly House Views
Intercession Good, Recession Bad
When this year began, most forecasters expected inflation to peak in the first quarter before beginning a sharp descent. The war in Ukraine, and the resulting spike in commodities prices, changed that. Latest headline inflation figures in the US, the UK and the Eurozone make for grim reading: 7.9%, 6.2% and 7.5% respectively. They are almost certain to rise further. Moreover, the pandemic, forgotten of late, continues. China in recent weeks has imposed strict lockdowns in parts of the country, including Shanghai, and a new subvariant has led to a surge of cases in Europe. That may well prolong issues for already stretched and disrupted supply chains.
On the plus side, there is little sign so far that rising prices or fear of Covid have slowed consumer appetites. This is particularly true in the US, which leads the global business cycle – demand for everything from cars to furniture to nights out is booming. Household balance sheets in the US are in good shape too as wealth has soared since the start of the pandemic, when wages were largely backstopped by the government while services spending was slashed. US households are currently sitting on $2.3 trillion in savings (10% of GDP) above pre-pandemic levels, which is helping absorb the current inflationary pressures and keep the party going.
In turn, businesses are hiring to meet this robust demand. The US has regained more than 90% of the jobs lost in the pandemic, adding 431,000 positions in March alone. Booming job increases have been seen in sectors such as travel, live entertainment, indoor dining, bars, museums and historical sites. The unemployment rate has fallen to a near record low: 3.6%. The demand for workers is yielding strong wage growth. The latest US Non-Farm’s Payroll showed wages rose by 5.6% in the year to March, well above the 2% to 3% range in the years following the Great Financial Crisis. Notably, the biggest gains in US wage growth have occurred at the bottom end of the income distribution – in the leisure and hospitality industry, pay is up 14.9%.
Inflation expectations must remain anchored at all costs
Indeed, while businesses are reporting widespread cost pressures and hiring challenges, forward revenues, earnings, and profits margins continue to be at record levels. However, too much of a good thing can make it a bad thing – are we heading towards a dreaded wage-price spiral?
Essentially, a wage-price spiral is where rising prices cause workers to demand higher wages, which in turn cause businesses to pass on higher wage costs to their customers, which then reinforces higher prices. This vicious cycle must be avoided because it unmoors inflation expectations, which must remain anchored. Should firms and households find themselves unsure about the long-term inflationary outlook, they don’t know how much to invest or save, or how to structure long-term contracts, amongst other things. It can result in a deep loss of confidence, which is the lifeblood of an economy. Without confidence – and anchored inflation expectations – we enter a world of painful recession, unemployment, widespread misery and even “lost decades”.
Is the Federal Reserve Bank (Fed) going too far, too fast?
Luckily, market indicators of long-term inflation (e.g. 10-year breakeven rates) do not imply that expectations have risen too far beyond most central banks’ 2% targets. More plainly put, most economic participants still expect the Federal Reserve to achieve 2% inflation over time. However, for the Fed to maintain its credibility, it has had to radically pivot from a “lower rates for longer” stance at the start of the year. to signalling 50 basis points rate increments for the first time since 2000!
The Fed’s sudden, dramatic shift makes perfect sense. One, it will temper red-hot consumer demand. Two, it is critical in the context of the Fed maintaining the credibility of the long-term inflation target. However, it comes with one big risk: is the Fed likely to go too far, too fast, and end up inducing a recession anyway?
William Dudley, a former president of the Federal Reserve Bank of New York, has called a recession “virtually inevitable”, arguing that the Fed had begun raising interest rates too late, therefore it is being forced to “slam the brakes” as opposed to merely tapping them. He is a serious voice, amongst others, and it would be wise to pay heed.
Nonetheless, a recession does not appear on the horizon at present by the factors we follow. Far from it. Corporate profits are strong, households have trillions in savings, and debt loads are (relatively) low. Moreover, the Fed may well hike less than is currently expected by markets, should inflation begin to dissipate faster than forecast. This is more than possible, especially if the geopolitical risk premium on commodities fades.
In addition, the coronavirus-related shutdowns in China may also be short-lived – despite poor local vaccine efficacy – as the country seeks other solutions. For example, Chinese authorities have signed a deal to commercialize Pfizer’s Paxlovid, a drug highly effective at preventing hospitalization if taken within five days from the onset of symptoms. China may simply be waiting for sufficient supply before announcing relaxed vaccine rules.
Perhaps most saliently, recent data suggests that many workers who had been kept out of the labour force have been returning as pandemic-related factors ease. More than 400,000 people re-joined the US labour market in March, taking the labour force participation rate (the share of adults who were working or actively looking for work) to 62.4%, the highest since the pandemic. Among people in their prime working years (those ages 25 to 54), the return has been even more impressive. The pressure on wages, and thus inflation, will be blunted should we return closer to the pre-pandemic participation rate of 63.4%, which we expect.
There is much moving in markets, some of which is described above. As always, we choose to rely on our investment process to guide our investment decisions. It is currently telling us the following:
The economic outlook remains robust judging by the forward-looking indicators we measure. Recession does not appear on the horizon, even in Europe, and economies are likely strong enough to absorb higher rates and a gradual “normalisation” of monetary policy. Purchasing Managers’ Indices (PMI) for most major global economies are well into expansionary territory. While financial conditions have tightened, it remains relatively easy and cheap for most households and companies to borrow money. Jobs are plentiful. Corporate revenues, earnings and margins are all at (or near) record territory.
Valuations had been our biggest source of concern coming into this year but have moderated, as prices for equities have fallen this year while earnings expectations have remained anchored. Bear markets rarely occur with earnings healthy and rising. Moreover, while equities are still not cheap globally, particularly in the US, they are cheaper than they were. Equities remain more attractive than government bonds, where the real yields remain negative (albeit less so). It is also worth remembering that equities tend to be a better hedge against inflation than bonds, as are commodities.
Momentum for equities had turned negative over the first quarter. This is a signal to cut some risk. It pays to remember that bull markets, such as we have been in until recently, tend to deflate over many months, not “burst”, as is commonly perceived.
Sentiment in markets is neutral by the factors we look at. Indeed, global equities are withing spitting distance of their all-time highs despite many of the headwinds.
On the balance of the factors above, we continue to maintain a Neutral stance to risk. We still believe the case for risk-taking is supported given the strong economic backdrop. However, increasing volatility and negative momentum give us cause for concern. We continue to hold a stable of diversifiers (cash, government bonds, gold, hedge funds and a Tail Risk Protection Note) in order to help offset downside risk.
As ever, we are constantly monitoring markets. Should conditions change, particularly with regards to the economic regime or signals from our valuation, momentum and sentiment framework, we will adjust our asset allocation accordingly.
Process and Convictions
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Unless otherwise specified, all statistics and figures in this report were taken from Bloomberg 03/25/2022.