DO YOU BELIEVE IN ROCK ‘N’ ROLL?
But the market wants to believe. It doesn’t mind the rock of oncoming recession because it looks through to the roll of falling interest rates and a return to cheap money. It’s all positive if recession is coming resolutely but softly in nominal terms, and disinflation (not deflation) is coming fast and loudly. This is reflected in the interest rate cuts already priced in for the second half of 2023.
But the disinflationary trends may be slower to emerge, because of the stock effects of the massive monetary easing covid precipitated. Many leading economic indicators suggest slowing growth, but the labour market seems stickier in its hotter state (Figure 11).
So disinflation may be coming too slowly, while a profits recession is coming faster, and the Fed is going to stay restrictive for longer.
Of course, exogenous developments – including a potential resolution to the Ukraine war, the end of yield curve control in Japan and the reopening of the Chinese economy post zero covid – could affect markets for good or ill.
For now, though, the Goldilocks narrative is back. But it seems to be chasing rather than driving price action, which would be consistent with the rally being driven by repositioning and technical factors.
SHE JUST SMILED AND TURNED AWAY
It is hard to have high conviction on any particular pathway. A Goldilocks fairy tale for 2023 can’t be dismissed completely; the data and events could coincide to deliver the ‘not too hot, not too cold’ outcome. But it’s a walk in the dark through a dense forest to get there and, even if we do, a Goldilocks economy does not guarantee a Goldilocks outcome for corporate earnings. ‘Just right’ for the economy might still equate to ‘cold porridge’ for corporate profits if margin pressure bites. And cold porridge won’t keep the bears away.
Source: US Bureau of Labor Statistics
Liquidity remains a key consideration. It is difficult to call an end to the bear market whilst the Fed is still draining reserves.
This is a function of explicit balance sheet policy, QT and interest rates, which motivate savings to shift from bank deposits into MMFs.
Predicting the short run pathway of reserves is difficult, but we know the effect and intention of policy is to shrink them further. While that remains the policy, risk-on interludes and Goldilocks narratives should be treated with caution. To get bullish, we need to see a proper Fed pivot, not a Fed pause. We need confidence in interest rate cuts and QT being paused. Or deployment of the treasury put.
SINGING, “THIS’LL BE THE DAY THAT I DIE”
In the end, inflation will fall down and play dead in 2023 even if it doesn’t fall fast enough to bail out markets from the Fed’s liquidity drain.
When inflation has fallen, many will think we can return to the pre-covid regime. That would be a mistake. The system is now more capable of generating inflation than the prior regime conditioned us to believe.
Here’s how this might unfold. Fiscal policy has proved effective at stimulating the economy directly, rather than relying on monetary policy to be transmitted via Wall Street, with all the inequality that generated. Unfortunately, the UK’s recent experience has scared governments, so fiscal policy is unlikely to be used pre-emptively. Unemployment will first have to overtake inflation as the political issue of the day.
When stimulus comes, it is likely to take the form of industrial policy, reflecting the growing strategic competition with China. Spending will be targeted at strategic industries, defence and the energy transition.
In the US, the treasury market will need to be relied upon as a source of stable funding. Currently, foreign owners dominate the market (Figure 12).
Domestic ownership of US bonds will probably have to increase, with banks and their broker-dealers needing to own more and intermediate more. So I expect policymakers to reduce balance sheet constraints to improve liquidity and let banks own more bonds.
Because all governments face the same strategic challenges, industrial policies are likely to direct resources at similar things. Consequently, when policy turns stimulatory again, we’re likely to revisit supply side constraints and bottlenecks. Geopolitics will also keep throwing in disruptive curve balls, whether in the South China Sea, the Middle East, Pakistan or around Russia.
Source: Federal Reserve