Markets signal Fed will blink in its face off with inflation
The dilemma for both government and markets this year has been to know which of the conflicting dual mandates the Fed should follow.
One the one hand, it is tasked with fighting inflation by slowing the economy. The strategy is: raising unemployment, depriving workers of leverage, lowering wages, and lessening cost pressures on business.
On the other hand the Fed is tasked with fighting unemployment by triggering inflation. The strategy in that case is to punish savers by debasing the value of their savings in order to stimulate spending.
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Different ideological camps and different political constituencies tend to favor one mandate or the other. Traditionally, conservatives (nicknamed "hawks") emphasize the inflation-fighting mission, and liberals emphasize the unemployment-fighting mission (nicknamed "doves").
The current Fed Chairman, Jerome Powell, was initially appointed by President Trump, a Republican. President Biden was under some pressure from his own party to replace him with the very dovish Lael Brainard. Biden compromised by reappointing Powell, but counterbalancing him by putting Brainard as Vice Chair. That shifted the Fed towards an easier money power balance.
Unsurprisingly, we ended up with almost 10% inflation and a Fed which was slow to fight it. Eventually, this year the Fed found some backbone and has been embarking on monetary tightening, but that appears to have shifted in the last week.
Last week's investor behavior was about a number of factors. Various housing reports were worse than expected. The Housing Index and the Housing Starts were both down from the prior month, and also lower than expected. Existing home sales were very slightly higher than expected. So in general, the housing market, a key part of the economy, was disappointing. As we have seen many times, however, disappointing economic news is often good news for investors, because economic news is read through the filter of how it will affect the world's largest investor: the Fed. When the economy looks too weak, investors often conclude that the Fed will create new monetary base and use it to invest in markets. This drives up the price of assets (because it's buying them) but also increases the risk of inflation (because it's buying assets with newly created money).
In addition, on Friday Brainard made remarks that indicated the emergence of a dovish dissenting faction. There were reports that the head of the San Francisco Fed and the Chicago Fed were also wavering in the fight against inflation. In response to the Fed dissent the following happened:
- Gold rose.
- The dollar fell.
- Futures markets signaled smaller Fed hikes in the future.
- Most stock markets rallied, outpacing most bonds.
- Inflation-hedged bonds rallied.
- Commodities generally rose.
In other words, with the exception of some bond yields, we saw a dovish trade. Markets acted as though the Fed would leave more monetary stimulus in place than had previously been thought. In addition, it was a mixed "risk on" trade in terms of growth. We also saw a predominance of pro-growth trades (of course, this means less downturn), but we'll see below that most (but not all) the variations in sectors within the equity asset class were pro-growth. Remember, markets have seemed to rule out a genuine upturn: the debate has been about how bad the slowdown will be. Last week 'less bad' mostly prevailed. It was also an 'inflation on' trade for the most part. And it was a 'U.S. on' trade, meaning markets acted as though the world will be worse off than the U.S..
These comparative returns between asset classes such as stocks, bonds, currencies, and commodities are consistent with the following account: the Fed is losing its nerve, and will be less aggressive in fighting inflation, and therefore less successful in avoiding it. The upside is that it is less likely to crash the economy.
This coming week there will be a wide range of data releases: some more housing data, some inflation data for personal consumption, third quarter GDP, and a number of manager surveys for the current month. The GDP data will tell us whether the technical recession of the first half of the year extended into the second half of the year (which we doubt). The surveys will signal whether the 4th quarter is looking slower than expected.
Any one of those items has the potential either to intensify or reverse the narrative, and market dynamics along with it. For example, if GDP or manufacturers surveys are surprisingly weak, that could confirm this week's shift towards expectations that the Fed that will loosen up a little. The same thing could happen if there is a spike in unemployment claims.
Real Estate: REITS performed modestly well, which one would expect given the prevailing themes of the week: falling rates, improved growth outlook, and rising inflation risks. REITS do well with inflation (real estate is an inflation hedge), growth (because in seasons of higher growth renters can afford to pay more), and low interest rates (because it is a debt-dependent sector). Last week they were given all three of those things. REITs performance is typically between that of equity markets and bond markets, and that held true last week.
U.S. Stock Market: Domestic equity markets were generally up last week, with growth stocks significantly overperforming value stocks. That overperformance occurred among the large, mid and small size company categories. That overperformance could reflect at least two factors: growth stocks are more dependent on low interest rates than value stocks and they are also more dependent on high growth rates. Last week was generally a falling expected rates trade, at least after the Fed dissent, and a growth trade. Growth stocks tend to overperform value stocks during times of rising economic growth expectations (because growth presumably helps earnings actually deliver on growth companies' high expectations). They also tend to overperform value stocks when interest rate expectations are falling because their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings. At the end of last week growth stocks got both the things they needed, higher likely growth and less discounting of that growth due to lower rate expectations.
The difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, etc., were a mixed bag but most showed a more pessimistic growth shift.
So, the lower future rate picture was fairly clear in the data, but the softer landing picture was a bit fuzzier.
VUSE significantly underperformed the S&P, probably due partly to its value discipline. Value lagged last week. It also probably didn't help that large cap tended to beat both mid and small cap. As an all-cap fund, VUSE is weighted more towards mid and small cap stocks than the celebrity funds, which are typically weighted towards the larger companies which did well last week. In other words, last week the all-cap approach was probably a hindrance to VUSE relative to the S&P, and so was the value approach.
International Stock Markets: International equity markets were generally up for the week, but U.S. domestic equity markets were up more. This was despite a falling dollar. In other words, foreign markets generally performed worse than U.S. markets mostly because those markets fell, not mostly because of currency effects. This all suggests that markets think the rest of the world will have a harder landing than the U.S.
We should point out that, the dollar weakness was not universal, with some dollar indices rising and some falling depending on which foreign currencies the dollar is compared to by the different indices. For example EM underperformed DM significantly: both the currencies and the markets. Last week international markets returns varied both by geography and level of development. Asia was hit harder than the rest of the world and EM was hit harder than developed.
Bond Markets: Bond markets were generally (but not universally) slightly down last week, but up after the dissenting voices from the Fed were reported on Friday.
But the real story is found by comparing different types of bonds, at individual sectors. The story was consistent with the softer landing (just as the stock sector dynamics we described above were), with high yield bonds and investment-grade corporate bonds significantly overperforming treasuries.
The growth thesis is simple: when business slows down, companies find it harder to make their debt payments. So lower credit quality bonds are more likely to default and so forward-looking investors sell them now.
On the inflation side, TIPS over-performed non-inflation-protected treasuries. When inflation hedges do better than the alternatives, that tends to mean investors think inflation is more of a risk than they did before. The yield spread between TIPS and regular treasuries widened, which is an indicator of rising inflation expectations. Remember when the price goes down, the yield goes up. So if the price of TIPS goes up, the yield of TIPS goes down, and if the price of regular treasuries goes down, the yield of regular treasuries goes up. These two changes in price widen the gap between the two yields, which is considered a pretty pure expression of inflation expectations (in fact, it is called the "inflation breakeven rate"). This inflationary market signal agrees with the inflationary message of a falling dollar, and rising gold, and with the thesis that the Fed is losing its nerve in the fight against inflation.
Jerry Bowyer is financial economist, president of Bowyer Research, and author of “The Maker Versus the Takers: What Jesus Really Said About Social Justice and Economics.”
