The Federal Reserve is doing something else than what it says it is doing. At last week’s FOMC meeting, Fed chief Jerome Powell said that “the committee is not trying to cause a recession”. Yet it is clear that the Fed is directly linking a recession to lower inflation risks and that the Fed does want to fight inflation.
Current inflation is high and it even seems that inflation in the United States has not peaked yet. This means that the Fed still has more work to do. Although substantial interest rate increases have already been factored into the bond market, the likelihood of a recession increases with further action. Powell continues to set himself up as the ultimate inflation fighter, with Paul Volcker as a shining example. The dove that became a hawk.
Yet Powell never seems to want to go as far as Volcker, who eventually raised real interest rates to 5 percent. Powell remains a dove in hawk’s feathers. That does not make it any easier, because the only thing that interests financial markets is what the Fed is going to do. Any more interest rate hikes will cause a (profit) recession and rising unemployment, a combination that will ultimately depress inflation.
Not the ideal solution for financial markets. Only when the market realises that inflation has been contained the stock market can recover. In the meantime, there are three factors that may cause the Fed to ease policy a little sooner: unemployment, financial stability and oil prices.
Rising unemployment
Predicting a recession is far from easy. The US is a net exporter of energy, its housing stock is extremely low and its financial system is sound. US consumption (69 percent of GDP) is still benefiting from the extra income during the pandemic and inflation may even cause consumption to be brought forward. There goes your recession.
History shows that only a limited rise in unemployment often coincides with the start of a recession. That is often the moment when consumers start to keep their hands on their purses. Retail sales in May already showed that consumers are less inclined to make larger purchases. The falling stock market is also causing a negative wealth effect.
For Americans with a neutral portfolio, this quarter is likely to be worse in terms of returns than the worst quarter of 2008 (-14 percent for a 60/40 portfolio). The housing market is healthy, but interest rates have risen so fast that the coming months will feel like 2007/2008. Finally, the savings rate has fallen to its lowest level in 13 years, while consumer credit has risen to its highest level in 20 years.
Despite wage growth, real disposable income is falling and, given the increased inflation expectations among consumers, they are counting on a real decline in disposable income over the next 12 months as well. In this environment, consumers may stop spending quickly once the labour market starts to shift.
Financial stability
The financial sector in the United States is healthy. But since the Great Financial Crisis, interest rates have been at zero and trillions have been poured into the US economy through various buy-back programmes. Now that interest rates are rapidly normalising, it is inevitable that this will hurt somewhere. The tide is out, so now it’s a matter of seeing who doesn’t have their swimming trunks on. That could be in the corporate bond market, shadow banking, emerging markets, private equity or even the crypto-currency market.
These are all categories that are sensitive to higher interest rates and also categories that are now less able to obtain capital. The big question is whether a problem here can cause a systemic risk. At such a moment, the central bank has little choice but to support the market, but only if the problem is big enough.
Oil prices
A fall in the price of oil below 100 dollars per barrel would give the Federal Reserve some more room to manoeuvre. With supply currently tight, however, much would have to change. A deal with Russia is needed, but after Biden called Putin a war criminal and accused him of genocide, the White House seems to be pushing for regime change.
It is possible that a deal with Iran and/or Venezuela could also help bring down the price of oil, but it will not be easy to replace the 2 million barrels a day of Russian oil that is currently being missed. The risk is rather that the oil price will continue to rise. (Strategic) stocks are still being reduced and 8 of the 10 largest OPEC countries are struggling to meet agreed production targets. For years, there has been completely insufficient investment in energy production and it will take years before there is sufficient supply again.
Looking for a bottom
As long as the Fed sticks to fighting inflation, share prices may fall further and interest rates may rise further. When the probability of a recession clearly increases, long-term interest rates can be expected to start falling (and the curve to invert). Similarly, when there is a major financial accident, US government bond yields may fall rapidly.
When rates start to fall, the interest-sensitive segments of the equity market (growth stocks including Big Tech, early-cyclical stocks and homebuilders) will benefit. But then inflation has to cooperate too. For now, value has been preferred to growth for some time, investors prefer energy to tech, they prefer large caps to small caps, they prefer investing in quality to momentum and defensive has taken precedence over cyclical for the time being. This has been going on for some time, but could turn quickly the moment the Fed pauses.
If the Fed does not pause, its fight against inflation will hit the economy and therefore profits. This has not yet been factored into expectations. Inflation is likely to prove much more persistent than what the FOMC now seems to be counting on. Nowhere does the FOMC state that inflation is temporary, but when the FOMC’s inflation forecast for 2024 is 2.2 percent, the Fed is still counting on a relatively soft landing. In that case, disappointing inflation numbers will not bring calm to financial markets.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His contribution appears every Thursday on Investment Officer Luxembourg.
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