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Long and variable lags

16th December 2022


  • The rally in risk assets up until this week has largely been driven by optimism around inflation and the outlook for monetary policy; investors appear to be increasingly leaning towards a soft landing scenario

  • Although inflation may well have peaked in this cycle it remains to be seen how quickly it comes down

  • As Fed policy impacts the economy via financial conditions, higher equity prices and lower bond yields may require the Fed keep rates higher for longer

  • Equally, as monetary tightening impacts the economy with long, variable and uncertain lags, there remains a risk that at some point we see a non-linear response to the cumulative amount of tightening, particularly when excess savings have been run down

  • From an asset allocation perspective, there remains a strong macro case for considering diversifying strategies like managed futures, trend following and global macro

Although the traditional Santa Claus rally hasn’t materialised, there had been a notable improvement in sentiment in the last two months as improving inflation in the US and Europe boosted hopes of a soft landing.

Global equities, risk assets and government bonds have rebounded to varying degrees, initially finding a bottom even as the September US inflation data disappointed in mid-October and gaining momentum in the aftermath of October inflation print.

The magnitude of the rally (with the Dow Jones Industrial Average up over 20% from its lows at one point) and the internal composition of the move (with strength in some cyclical sectors like materials, industrials and to an extent financials) raised the suggestion that perhaps the market was signalling an improving economic outlook.

According to FactSet, industry analysts in aggregate forecast 5.0% growth in EPS for the S&P 500 next year and a rise in the S&P 500 of about 13.5% by end-2023.

The general improvement in sentiment could be seen as somewhat surprising given:

· The yield curve in the US continues to invert, historically seen as a predictor of a recession

· The Fed is still in the midst of a tightening cycle signalling further rate increases to come

· There is a widespread expectation of recession amongst private sector economists

This week, the release of the November CPI appeared to offer further ammunition for the bulls with core CPI rising just 0.2% mom.

However, the market reaction has been muted and the inability of equities to hold gains after a positive CPI this week is a near-term negative.

Other technical indicators are also flashing caution:

· The S&P 500 has again failed to close above its 200-day moving and has traced out a series of lowers highs since January of this year

· Although the DJIA made a higher high in October the uptrend was not confirmed by the Dow Jones Transportation Index

Although the inflation picture is improving it may be that a soft landing is now factored into equities leaving the market vulnerable to disappointment.

The case for the bulls

The bull case for equites rests largely on the outlook for the Fed and in turn inflation.

With the November core CPI rising 0.2%, the slowest rate since August 2021, and following a 0.3% print for October, there is a case for believing that at least a cyclical high in inflation has been reached. Although core CPI was 6.0% yoy, the 3mth and 6mth annualised core CPI have shown clear deceleration.

The breakdown of the data also offered some encouragement. In his Brookings speech Powell set out how the Fed is thinking about inflation, decomposing it into goods inflation, housing inflation and core services ex housing.

Goods inflation is declining reflecting an easing of COVID related disruptions and the shift in consumption back to services.

Although the housing component in CPI and PCE inflation is still rising there is a recognition that the rent element is a lagged measure and spot rents (which are more reflective of the current market) have already turned down.

For example as economist Jason Furman has pointed out, substituting spot rents into the core CPI puts core CPI rising at just 0.7% ann over the last three months, trending down from a peak of over 16% (on a 3mth ann basis) in 2021.

However, the outlook for core services inflation ex housing is more mixed. The Fed is focused on wage growth as the primary driver of inflation and to date there are only tentative signs of a slowdown in wage growth.

Powell again picked up on this theme in his post FOMC press conference citing the strength in the average hourly earnings data in the recent payroll report. Average hourly earnings grew 5.1% yoy in November, consistent with well above target overall inflation, with the 3mth ann. number showing renewed acceleration in wage growth in recent months.

So in aggregate while there are reasons for optimism on inflation, given the labour market picture it is possible that inflation may be sticky in coming down.

Other factors have also contributed to the shift in sentiment.

The UK’s disastrous mini-budget and ensuing liquidity crisis for UK pensions added momentum to the global bond sell-off in late September and early October. With the UK back on the path to more orthodox fiscal policies UK 10-year yields have fallen from over 4.5% to 3.2%.

The reversal in the US dollar has also aided sentiment. A key concern two months ago was that the relentless rise of the US dollar would drain liquidity from the global monetary system, and add to the pressure facing emerging markets in particular. A stronger dollar was also adding to the terms of trade challenge facing Europe and was a headwind for US earnings. A weaker US dollar alleviates these concerns.

In sum, the case for the bulls rests on an improving inflation picture allowing central banks to pivot earlier with lower bonds yields and a weaker USD key positive for global risk assets.

An unusual cycle

However, if indeed equities have bottomed and move higher from higher it would be unusual relative to the historical patterns.

For one, the Fed has flagged that policy is only now entering the “moderately restrictive zone”. In previous cycles equities tended to rally early in the tightening cycle and sell off when policy got restrictive.

S&P 500 and Effective Fed Funds Rate 1998-2020

For example, the S&P 500 rallied in 1999 as the Fed raised rates to 6.5%, before finding a peak in 2000 and then entering a two-year bear market as the bubble unwound. Between 2003 and 2007 equities trended higher as the Fed raised rates from 1% to 5.25% and only started to reverse in late 2007 after policy got into restrictive territory.

In the last tightening cycle the Fed raised rates once in 2015 and resumed the rate rising process in earnest in late 2016 and into 2017. Again, initially equities held up and only declined in Q4 2018 at the end of the tightening cycle.

So in a typical tightening cycle equities initially rise as rates start to rise, find a peak when policy get restrictive, decline as signs of economic weakness emerge and find a bottom when policy pivots to easier monetary policy.

This cycle has been different. Equities started to decline in January as expectations of higher rates took hold and continued to decline as the market factored in a progressively higher peak for Fed funds. Now equities are rising even as the Fed is signalling that it will raise rates another 50-75bps and bring policy to a moderate restrictive stance.

The problem with that is that higher equity values, lower bonds yields, lower credit spreads and a weaker US dollar are all stimulative and contribute to easing financial conditions. Financial conditions rather than the Fed funds is what influences the economy and it seems unlikely that the Fed would want to encourage easier financial conditions, particularly as the Fed has been at pains to avoid the mistake of the Volcker Fed in 1980 in easing too quickly when inflation initially started to decline.

So it is conceivable that the recent easing of financial conditions may force the Fed to either tighten more or keep rates higher for longer which may ultimately circumvent the risk rally.

An ontological error?

The recent optimism in markets stands in sharp contrast to the outlook presented by economist William White when I interviewed him recently on Top Traders Unplugged.

Bill White has had a career as a policy advisor and policy maker spanning six decades with stints at the Bank of England, Bank of Canada, the BIS and OECD. He came to prominence in the 2000s when he famously warned Alan Greenspan at the 20003 Jackson Hole about the peril of easy money and excessive credit growth and repeated the warning in 2007 just before the Global Financial Crisis.

One of Bill’s core beliefs is that central bankers, and policymakers in general, have continued to make a fundamental mistake when analysing the global economy, what he calls an ontological error.

Specifically, they continue to believe that the economic system is linear, stable, knowable and predictable when in fact the global economic system is a complex adaptive system that is inherently unstable.

As Bill puts it, the economy is “a system where policy can have different effects over different time horizons, many unintended consequences and where there is no “equilibrium”.

That insight could also be highly relevant for investors at the current juncture, when thinking about the impact of rising interest rates.

As the global economy has slowed modestly and there are initial signs of disinflation, investors may be extrapolating in a linear fashion the improvement in inflation and the moderate slowdown in demand and inferring a soft landing.

Instead when thinking about the outlook it is important to keep in mind the unpredictable nature of a complex adaptive system and the potentially nonlinear relationships.

In the current scenario that means thinking about the long, variable and uncertain lags with which monetary policy impacts the real economy.

Tighter monetary policy impacts aggregate demand primarily by slowing consumption and investment. The impact of a given increase in rates may vary over time depending on a number of factors such as the level of indebtedness, the relative shares of fixed rate and variable rate debt, income and profit growth and the general mood amongst consumers and companies (what Keynes called “animal spirits”).

Apart from the direct effect of higher rates on consumption and investment there are the second-order effects and feedback loops. Higher interest rates may push down asset prices and induce negative wealth effects. Falling asset prices may force leveraged asset holders to liquidate investments and lenders to levered asset owners may see those defaults on loans.

Higher US rates may support the US dollar; a higher dollar can raise funding costs for foreign countries and companies who have borrowed in dollars. To the extent that higher US rates support the dollar, other central banks may be more inclined to match those higher rates and tighten policy aswell. The cumulative impact of a number of central banks tightening may be greater than the sum of the parts.

More generally looking at the experience in the last five tightening cycles in the US we can see big variation in the magnitude and timing of the impact of higher interest rates on the economy from the soft landing experience of 1994/1995 to the Global Financial Crisis following the 2003-2006 tightening cycle.

One reason to believe that we may again see a nonlinear impact from rising rates is because the economy many still be feeling the effect of the pandemic. During the pandemic consumers increased savings as they stayed at home and received income support from governments resulting in a huge rise in savings.

That is reflected in the US in M2 growing by 40% between Dec 2021 and Dec 2019 (M2 consists of currency in circulation, bank deposits and retail money market funds). Although M2 growth is now slowing rapidly it is important to differentiate between the stock and the flow. Yes, money growth is slowing but the stock of excess money is still in the system.

What that means is that consumers have a buffer of savings to tap to mitigate the impact of rising interest rates. The recent fall in the savings rate (i.e. the amount of savings people are putting aside out of current income) down to 2.3%, close to an all-time low is also evidence of this.

At the same time although consumer credit growth has slowed somewhat it is still growing at a healthy rate of about 7% yoy. Effectively consumers are putting aside less out of their current income and instead relying on credit and their stock of savings to maintain their consumption levels in the face of higher rates and higher inflation.

In the short-term that means demand is holding up and the negative impact from higher rates is being blunted. However, on current trends the excess savings will diminish as we go through 2023 and the risk is that the combination of even higher debt services costs and lower savings balances could produce a sharp weakening in consumer spending and a hard landing.


Looking ahead, with US 5-year breakeven inflation rates down to 2.3% from 3.5% and analysts forecasting 5% earnings growth for next year it appears that the market is betting on a soft landing scenario.

While that is certainly a plausible scenario one can make a case for any of five broad scenarios of soft landing, goldilocks, hard landing, stagflation or inflationary boom for the US economy for 2023.

Our subjective assessment of each are set out below.

Given the almost universal expectation of recession next year and the fact that recessions are typically a surprise it is tempting to take the contrarian position of growth surprising to the upside.

That could either be a goldilocks scenario of growth staying strong with a fall in inflation (driven by an easing of supply side disruptions) or the inflationary expansion scenario of growth picking up again and inflation remaining stubbornly high (effectively monetary not having a significant effect on the economy or having a delayed effect).

The former would be very favourable for risk assets whereas the latter would be negative as the Fed and global central banks would tighten by more than is currently priced in. The latter scenario would also raise the probability of a hard landing in 2024.

Neither scenario can be entirely ruled out but both seem like outlier scenarios. As global central banks are actively trying to slow growth via monetary tightening a slowdown next year seems more likely than not, even if it is the consensus view.

Whether the slowdown takes the form of a soft landing, hard landing or stagflation is an open question.

It is conceivable that if inflation falls, real incomes will be boosted and consumer spending may hold up resulting in a soft landing or only mild recession. While that scenario may well be the most likely scenario of the five possible scenarios we still put that at only about a one in three likelihood.

In contrast, the probability of either a hard landing or a stagflation scenario (both which would be negative for equities) is arguably higher.

As inflation has eased recently and equities have rallied the market appears to be downplaying the stagflation scenario.

That may be premature. Only three months ago at Jackson Hole one of the main themes which emerged from many economists and policymakers was that a more challenging environment for policy lay ahead as many of the disinflationary forces of the last few decade, such as globalisation, favourable demographics and a stable geopolitical environment, are in the process of reversing.

From an asset allocation perspective one of the key features of 2022 was the concurrent declines in bonds and equities which revealed the underlying fragility of the 60-40 portfolio.

While a soft landing would certainly be favourable for both bonds and equities, and a hard landing would probably see bonds resuming their traditional role as equity diversifiers, the stagflation and inflationary expansion scenarios would again present environments that could be difficult for both bonds and equities.

As the combined probability of the two remans meaningful at about one in three it continues to point to support the case for investors considering diversifying strategies like managed futures, trendfollowing and global macro when thinking about asset allocation for 2023.

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