Why “Pivot” is the 2022 version of “Transitory”…..

Why “Pivot” is the 2022 version of “Transitory”…..

·         Stay Patient, yes inflation will come down lead by headline inflation as we project but given on our projections near central bank targets only by 2024.

·         Furthermore, we expect the Federal Reserve to continue to raise rates to 4.5% by year-end (+75 bps and +50 bps)

·         Mythical “pivot” to repeat as we did since May, will take longer than market participants are used to and we need to forget again the muscle memory of the era of easy money, central bank put, low inflation.

·         This is a process not an event. Hence, one payrolls or inflation print (we have another upcoming this week) does not change the trend.  Can create rallies or sell-offs but will not change the broader picture.

Will need many months of convincing improvement to change the trend for central banks. However, already the market will be focused on the economic impact of the higher rates.

Why?:

(1)     High level of headline inflation (8-9% in US and Europe), will take time to come down, to repeat, this the opposite environment of 2018, when Powell pivoted when inflation was 2.5% when unemployment was 3.5%...

(2)  Good news is Bad News again: Friday’s resilient non-farm payroll combined with a fall in unemployment to 3.5% and unfortunately falling participation rate. Resilient labour markets again highlights the issue that overall inflation this will be a longer process unless something  “breaks” beforehand.  Core inflation is above 6% in the US and wages and rents will take time to come down. The Atlanta Fed Wage Growth tracker is at +6.7%. Falling longer-term inflation expectations have not been a help in the short-term, as they merely illustrate rising recession risks.

(3) Energy prices are rebounding again, after the OPEC plus meeting supply cut and geo-political risk in Ukraine is worsening, which could complicate the rate of slowdown in headline inflation.

(4) Most importantly therefore, Central banks will be above neutral rate for longer than expected raising economic and financial risk. This means the central banks like Fed, ECB, BOE, etc will slow the economy and eventually inflation. This will stimulate recessionary and near recessionary conditions. Note monetary policy acts with long lags of 6 – 12 months.

Moreover, “good news” on a resilient labour market or looser financial conditions are not good news for risk markets as they both need to tighten for likely for longer to lower long-term inflation.  In short, we need “bad news” or sustained weakness in these areas. However, by then, the key for equity markets will be to assess the hit to supra-normal level of earnings from historic pandemic monetary and fiscal stimulus.

The “good news” is equities have already discounted a slowdown but not perhaps a longer recession, some opportunities if you are underweight equities but no green light yet. Average sell-off recession -38% and 447 days. This is why sentiment indicators have not worked for a broader and sustainable rebound.

The long the bear roars the more violent are the rallies…

In short, it is getting too late for any “pivot” to cushion the real economy in the short-term. The central banks are likely to remain on hold at year-end to see the impact of the economy after year-end. Consumption which is two-thirds of developed economies gdp is at risk. Mortgage rates in the US are 7%, even as they peak, the impact on the economy is just beginning. The two biggest components of consumption both housing and autos are rate sensitive. Inventory levels of retailers are rising.

Where are hawkish central banks, inflation for longer, getting increasingly priced in?

While the sell-off in equities is normal, this is the worse year for 10-year Treasuries since 1900. We turn Positive on US government bonds and on high quality US IG corporate bonds for USD-based investors. We also like short-term Gilts.

Gradually build exposure in the coming months…..