Three Times is a Pattern?
Monday, 15 April 2024 10:18
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Although not a disastrous figure, there is little doubt that the US CPI for March was not what the Fed was looking for.
The figure was important because it came after two poor releases, and economists had been hoping that March could deliver a cleaner picture with fewer impacts from the seasonal factors at the beginning of the year.
The immediate implication was played by markets instantaneously: Once is chance. Twice is coincidence. Three times is a pattern. Inflation is proving stickier than expected at a level that is a little too high compared to the Fed’s target (i.e. 3-4% vs. 2%). This implies the central bank is likely to remain in “very restrictive” territory for longer. So, markets removed another cut. At KECH, we also remove one cut from our four-cut scenario, keeping our cautious outlook on the US economy. We make no changes to our ECB scenario (four cuts).
Now looking ahead, how to position portfolios? We see three plausible reactions:
- The pragmatic “Momentum” approach would be to assume that it is premature to touch bonds until we see clearer signs of falling inflation (or some slower economic growth that could help to lower the inflation rate). Until then, decent economic growth and inflation favour earnings and stocks.
- The “Defensive” approach would be to consider that for the central bank to achieve a slower inflation rate, restrictive rates will have to be maintained for longer – and even potentially raised in the event that the economy were to stay as strong – so one moves to cash until inflation, or the economy cools down. Said differently, one doesn’t want to be long risk assets in a process in which the economic momentum will turn under the effect of the Fed’s fight. Bonds would remain vulnerable to a more hawkish stance until the economy starts to weaken.
- The “Dovish” approach would be to consider that the Fed will cut rates in any case, because rates are already very restrictive, inflation isn’t dramatically off target, and the Fed doesn’t want to stay there too long. It would be some sort of “inflation tolerance” scenario. In that case, real rates would come down (inflation breakeven would creep higher) and one wants to stay OW Stocks. In this case, the Fed plays down the US CPI release. It is very similar to the “Momentum” approach, but the implications for the dollar would be bearish. So far this year, the Fed’s credibility regarding inflation hasn’t been questioned. In that scenario, the market starts to doubt.
Is there a positive case for bonds in any scenario? With only two cuts expected by the market and 10-year Treasury yields at 4.5%, the risk-reward for bonds isn’t bad if one expects the economy to slow down later this year (as we do). But this trade is likely to pay off once the data supports this idea or depending on the Fed’s communication. As a reminder, in our own macro scenario, higher rates eventually filter through in the economy, weighing on investment and new hiring, and consumption patterns eventually normalise under the effects of a rebalancing labour market and falling savings. No recession, just a welcome slowdown for inflation.
What positioning will the market favour?
- First, we should not lose track of the broader context: equity markets have done well YTD, and the US elections are coming soon, which will increase the level of uncertainty. These two elements combined with a very attractive valuation of Defensives mean that the “Defensive” approach above could lure investors.
- Geopolitical tensions have remained acute and contribute to fuelling the “Dovish” positioning (which we typically played via Gold and OW Energy in our asset and sector allocation).
- Both the “Dovish” and “Momentum” positionings converge on Cyclical Value stocks (like Energy, Basic Resources), but they also converge on Technology or Growth stocks with pricing power. The AI boom is typically expected to provide extra earnings power to the Technology area. The problem of the latter is that investors have been particularly exposed to that already and valuations are high, hence any disappointment concerning the pace of AI adoption could be a blow in a context of high bond yields.
- Therefore, for investors that would like to remain significantly invested in stocks but that are worried by either the concentration risk in the US or the frenzy in AI, we believe the UK market perfectly fits the bill at the moment (see our report for further details).
A last word on currencies: one can also derive some interpretations from the above scenarios.
- “Momentum” and “Defensive” playbooks go along with a higher dollar. Markets trust the Fed on its inflation mandate.
- Yet as the “Dovish” playbook suggests, it all boils down to the central bank’s credibility: if the US is the only one facing a serious, long-lasting, and self-sustained inflationary problem, the value of the dollar might come down even if the rates differential increases.
- As you can tell by the immediate market reaction of the last two days, markets aren’t questioning the Fed, and the dollar has gone up.
In our case, we have never expected six or seven cuts as some did, because we were of the view that the Fed members would still be haunted by the 1970s and proceed cautiously. Yet, at the same time, the Fed set its communication in December 2023 in order not to spoil the opportunity of achieving a soft landing by being overly hawkish for too long. The jury is out on whether that will prove possible. In our view, the longer the central bank keeps rates high, the higher the probability of credit problems or economic slowdown. In that sense, we can understand the Fed’s willingness to start a slow and long cutting process, and we don’t read it as “dovish”. But by communicating as it did, the Fed triggered a massive risk-on rally which risks delaying its goal.
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