Is this the Powell Pivot?
Summary
The latest CPI data release suggests that inflation is starting to cool. While this is good news that the Federal Reserve’s restrictive policy is beginning to take hold of the economy, one data point is unlikely to cause a pivot in Fed policy.
Chairman Jay Powell said in his last FOMC meeting that he would rather overshoot shoot inflation because he has the tools to battle a recession. His stance on higher for longer still holds despite the CPI print.
Historically, a pivot occurs when the economy is slowing to the point of causing a recession, this is not a positive signal for the equity markets but is a positive signal for another asset class.
The market is, once again, hoping for a pivot; a pivot now could cause a mild recession; keeping rates high will likely cause a deeper recession. We believe a pivot is not likely for, at minimum, mid to late 2023.
Latest CPI Release
On Thursday, November 10, 2022, the Consumer Price Index was released, showing a year-over-year growth rate of 7.76%, and a month-to-month annualized change of 4% lower than the expectations of 6%. After the release, the market spiked, with tech stocks leading the way as the NASDAQ futures rose by roughly 7%. The market is pricing in a Federal Reserve pivot in the policy sooner rather than later. In the future, as goods disinflation accelerates and the momentum of core service inflation stabilizes, we should expect month-over-month core CPI prints to range around 0.30 to 0.4 percent. That implies that year-over-year core CPI will slowly trend down towards 4% by June 2023, a welcomed development. However, inflation is still too high for the Fed to feel at ease.
The downward surprise in CPI led to a decline in US inflation expectations, with the 1-year expected inflation now priced at only 2.89%. Despite the outsized front-end rally, the market-implied real Fed Funds rate ahead remains comfortably high.
While this current rally is welcome news for investors that are staying the course and are fully invested in the market, tactical investors like the money management system we run were left out of this rally. The extreme bond market reaction can be somewhat rationalized; the equity market rally was due to technical reasons—the fixed-income pricing within the realm of acceptable outcomes for the Fed. But, the equity market rally was much more pronounced and driven mainly by technical and institutional reasons.
Our Insights
By the end of 2023, our models point towards a rapid drop in inflation at or below 2% coupled with a likely earnings recession. With the dropping inflation, we can expect only partially good news in the future, followed by a rapid disinflationary trend in the second half of 2023. This second leg down (stage two of a market crash) will also associate with a higher unemployment rate and negative EPS growth.
Bull markets do not behave this way, but bear markets do.
When the market trends down in price, the drop is usually slow and methodical, with sharp rallies to the upside as short-cover buyers enter the market at any hint of positive news. While this is not always true, it makes sense for this rally. Combine that with end-of-year share buybacks and tax lot harvesting that sometimes causes a Christmas rally. Once these temporary market functions make their way through the tape, the market should continue towards the fundamental bias to the downside.
This rapid move to the upside might seem like good long-term news, but it is the opposite. Because the move to the upside was immediate, it confirms that we are still in a bear market. If this was a turning point, the market should have found a bottom, built a base, and methodically risen.
Fighting the Fed
Furthermore, the December 12th FOMC meeting should go through cold water on the rally, as I don’t see one CPI print as enough ammo for a shift in monetary policy. The reason for this opinion is from the horse’s mouth, Jay Powell. In the November FOMC meeting, he made it clear to the market that he would instead run a restrictive policy further than the off chance that inflation becomes entrenched. He is taking lessons learned from Paul Volcker, who was able to tame inflation of the 1970s and start the Great Deflation trend in the 1980s. In the early 1980s, inflation fell from over 10 percent when he began to turn off the monetary spigots to less than zero (deflation). Jay Powell has referenced Paul Volcker several times this past year, and I believe he has learned that he needs to do more to curb inflation for good, even if that means pushing us into a recession.
From everything we see from a macro perspective, the market is again rallying based on the hope that the Federal Reserve will change its tone to a more accommodative policy or, at minimum, pause its rate hikes. It feels a bit like Deja Vu from the June summer rally we experienced. Once again, I need to remind my clients and advisors that work with us not to buy into the fear of missing out on trade (FOMO). Our models all point to lower lows, albeit more toward the next FOMC meeting on December 12th.