Commentary: Approaching peak hawkishness?

Every month we discuss inflation it feels like Groundhog Day. While the trajectory of headline inflation appears to be rolling over, September US CPI was above expectations again at 8.2%. Core CPI continued to rise to a 40-year high of 6.6%. This quickly led the market to price in another 75bp hike by the Federal Reserve for November, but more interestingly, the market’s expectation for the peak in cash rates for 2023 jumped from 4.5% to 5%. To put this into context, the median forecast from the FOMC from the September meeting peaks at 4.6% and the most aggressive forecast is 4.9%. The last time cash rates hit 5% in the US was in 2006, when it peaked at 5.25% before crashing down to zero during the GFC.

In December 2021, the ‘new’ Taylor Rule1 suggested a Fed Funds rate of 4.9%. Our view back then was the Fed would have to be hawkish in the face of rising inflation (even before the Ukraine war boosted energy prices) and that recession risks were going to grow in 2022. This was one of the key drivers that led us to reducing risk and raising cash in the portfolio. Today, the market is pricing in a cash rate of 5% and a recession next year is mostly consensus. While it is too early to declare that the Fed won’t increase official rates above 5% in 2023, we are becoming more comfortable the market is pricing more realistic expectations than they were only a few months ago.

[1] The new Taylor Rule was part of the revision of the Fed’s monetary policy framework enacted in August 2020, as described in The Federal Reserve's New Framework and Outcome-Based Forward Guidance speech by Clarida April 2021.

Signs of the roll-over

Inflation will remain the key driver of policy and ultimately asset price returns. While there is still a long road ahead to bring inflation back to manageable levels, there are some signs that inflation will roll over. Global supply chain pressures, as measured by the New York Fed, are plummeting, which should help cap goods inflation going forward. Oil prices, which turbocharged headline inflation after the invasion of Ukraine, are now negative on a year-on-year basis. The so called ‘transitory’ inflation dynamics do appear to be moderating. But how about the stickier core inflation measures? Given the lagged effect of shelter in the US CPI data, this is likely to continue to rise over the coming months. That said, there are more coincident indicators for shelter that suggest this too will start to roll over. Home prices have come off (which leads by 12 months), coupled with apartment listings, and Zillow observed rents following suit (which lead by six months). Employment and wages remain the key metrics to watch, with the job openings rate, quits rate and wage survey measures also point to a peak in employment.

While an environment of surging inflation, rising official interest rates, and slowing growth presents a challenging and uncertain backdrop for risk assets, we recognise that these factors have been driving price falls across markets and are now becoming more realistically priced. Accordingly, valuations have improved in equities and credit, presenting a more constructive outlook for returns and a more asymmetric risk outlook than we have seen for some time. Furthermore, tentative evidence of a peak in inflation and the fact that significant monetary tightening is already priced, suggests that markets could rally from here on any moderation in the pace and size of tightening. Positioning surveys are also consistent with an oversold market, which would support this view.

Market edges cheaper

Equity valuations have clearly improved, albeit are not yet at levels we would consider as substantially undervalued in aggregate. To put numbers on the valuation improvement, the US S&P 500 had fallen -22% this year and at the start of November is currently trading on PE ratio of 18.3x (or 16.6x forward earnings). This compares to 32x at the peak late last year. While current PEs are still slightly above the multiples that typically occur at bear market bottoms (low to mid ‘teens’) and are yet to fully reflect recessionary earnings, they are not outside the range of past lows and are consistent with a significant cheapening of the market. In Australia, the S&P/ASX 200 is currently trading on 13.9x PE (13x forward earnings), well down on the peak multiples of 12 months ago.

Similarly, the rise in sovereign yields and the widening in credit spreads has improved the attractiveness of credit across the curve. We observe that, at a headline level, yields of close to 10% in global high yield debt and 6% in investment grade debt represent attractive medium-term opportunities. Like equities, the widening in credit spreads reflects the challenges posed by stubbornly high inflation, policy tightening and expectations of deteriorating profitability ahead, including some rise in corporate defaults. Using our credit valuation framework, credit spreads are broadly consistent with previous cycle wides, outside of the GFC. Measures of corporate health (net leverage and interest cover) encouragingly remain in comfortable territory even though both will likely deteriorate as growth slows and refinancing costs rise. Albeit with corporates having extended the maturity of their debt when spreads and yields were much lower than today, this impact may take some time to flow through.

The path ahead remains volatile

That said, downside risks are still significant and material (geo-politics, a financial collapse, or another shock to the inflation trajectory feature highly on this list). Markets are not yet so cheap that all these issues can be considered discounted, and we would expect that the path forward will remain volatile as investors and policy makers grapple with the challenges posed by stubbornly high inflation, declining profits, and a growing risk of recession. Big swings in assets prices (up and down) are not atypical in these types of environments (as they were through the late 1960’s and 1970’s when inflation was stubbornly high and rising). For the time being though, growth in key economies remains relatively resilient, given a rebound in service sector spending as economies re-open, more resilient at this point than we would have expected. The Atlanta Fed GDP Nowcast is growing at over 3% and earnings have mostly beat expectations. Monetary policy does operate with a lag and it may be another couple of quarters before the full impact of tightening to date (and expected) bites.

We have deployed some of our cash to take advantage of the improved valuations and medium expected returns. After adding to equities last month, we added another 5% in October, along with 2% in call options to take advantage of any year-end rally. This takes our equity weight up to approximately 28%, which is still well below that of a typical balanced fund. We also added 5% to global high yield and 2.5% to global investment grade credit.

It is still too early to call the bottom of this bear market; in fact, we still believe we have further to go. Typical bear market bottoms occur after a recession has been officially recognised, when the Fed has started to cut rates and the yield curve starts to steepen, among other triggers which have not yet been met. However, we believe these levels offer a medium-term opportunity. Our overall view remains bearish, with the US heading into recession and earnings potentially falling 15% in 2023. While investors’ positioning and sentiment are low, they have by no means capitulated. However, a lot more of this is in the price now than earlier in the year. We continue to hold elevated levels of cash at over 20% to deploy if we see even more attractive valuations appear in 2023.

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