Bulls hope that inflation will normalise quickly, earnings will hold up and the Fed will turn dovish. But why would inflationary pressures suddenly dissipate? If they do because covid disruption turns out to have been their main driver, surely we should also expect a surprisingly large fall in corporate margins, artificially inflated by the pandemic?
But, if covid-related factors just played a supporting role, a sharp drop in inflation will only occur because a recession has driven unemployment up meaningfully. How quickly can the Fed, so concerned about not letting the inflation genie out of the bottle, realistically reverse course when the inflation data improves? If the real economy is deteriorating fast enough to leave the FOMC confident that inflation will drop like a stone, why wouldn’t investors also price in significant downside to corporate earnings?
We don’t have reasonable answers to these questions. So we are left deeply sceptical of the cyclical bear market narrative.
Goldilocks’ return depends on a short and shallow recession, a rapid decline in inflation and an aggressive Fed pivot. Not impossible. But it is hard to see how all three can come to pass. And all three are needed if a benign market environment is to return quickly.
Source: Senior Credit Officer Opinion Survey of dealer financing terms, weighted net % of dealers reporting loosening of terms on new funding to hedge funds
Source: American Association of Individual Investors, sum of the average portfolio shares allocated to equity funds and direct equity holdings
A PRICE WORTH PAYING
Policymakers face their biggest inflationary test in decades. The reputations of both Powell and the Fed are on the line. Nobody wants to make the same mistake as Fed Chair Arthur Burns in the 1970s. No central banker dare say this out loud, but a shallow recession is a price worth paying for slaying the inflationary enemy. The main reason we are confident the Fed will be late to initiate an easing cycle is that central bankers clearly prefer this to be their legacy.
Recent history suggests otherwise – which is why investors expect the Fed to shift gear quickly once a recession starts. But this has not been a normal business cycle. Despite the recessionary dangers, central bankers fear entrenched inflation, not debt-driven deflation. Expectations of a pivot are set to be disappointed until either the real economy is in serious trouble or the rout in financial markets is sufficiently troubling.
For the moment, this Volcker-esque strategy has a political tailwind: inflation is sky-high and it matters to voters, while unemployment is at a multi-decade low. Powell can afford to sound and be tough. Intellectually, there is scant opposition. But these tailwinds could quickly disappear.