This time it’s endogenous
January made for a brutal start to the year in equity markets. What is it about the current sell-off that makes us more prudent than during other corrections in recent years?
As discussed in our global client webcast, the key is that the derating this time around is caused by a hawkish shift (one might say, a pivot) in the US Federal Reserve’s (Fed) tone, opening the door to a possible policy mistake on the part of the central bank. Indeed, after months of insisting that inflation was transitory, the Fed has decided that this is most likely no longer the case.
The central bank seems to be increasingly caving in to the mounting political pressure from a Biden administration that is unable to bring to life its inequality-reducing agenda in a midterm election year.
A difference of opinion – Camp A vs Camp B
Whether you see the Fed’s much harsher stance as the right or wrong policy path depends on which side you take in the inflation debate.
In the right corner, we have the ‘new regime’ crowd, which we can name ‘camp A’. Camp A believes that the US central bank is behind the curve and needs to hike rates several times in 2022 (how many times? 6, 7? We are still waiting for someone to forecast 8!), as well as to transition fast to quantitative tightening (QT).
In the ‘new regime’ mindset, the pandemic has left US households in a much better financial position, as people have used their stimulus cheques to pay down debt and save. This should permanently increase final demand.
Another argument of Camp A is that a wave of early retirements and rapidly rising wages in the US would add a second-round effect on inflation. Such demand-pull inflation could indeed warrant decisive hawkish action by the Fed.
In the left corner, we have the ‘unchanged regime’ camp, or ‘camp B’, to which we belong. We do not believe we are entering a new era for US consumers – as government transfers dry up, demand will return to pre-pandemic trends.
US households are approximately USD 30 trillion richer than they were before the pandemic, which, if anything, should make them more rather than less sensitive to the negative wealth effect of a bear market.
As to the shift in the US labour market, it is important to look beyond the headline average nominal wage growth figures. In aggregate, real wages are still below their pre-pandemic level!
An important point to make here is that as experienced and well-paid baby boomers retire, they are being replaced by cheaper millennials. Even if the wages of the younger workers grow at a faster rate, the aggregate wage cost paid does not.
Camp B believes that most of the current inflation spike is caused primarily by two factors: pandemic-related disruptions, including supply chain bottlenecks and sanitary constraints, and the cost of the energy transition. The former will resolve itself as demand and supply normalise and the pandemic becomes endemic, with Omicron hopefully being the last Covid-19 wave.
The latter is trickier to assess, as it represents a first in history – the first time we are attempting to replace a cost-effective energy source (ignoring externalities) with a new source that still requires substantial investments. We believe that this could cause higher energy prices in the medium term, but that it should spur productivity and lower prices in the longer term.
In any case, there is not much the Fed can do to tackle either of these factors, except for destroying final demand through the indirect impact of a negative wealth effect, as monetary policy does not transmit through the credit system but through asset prices nowadays. All the Fed can and should do is to concentrate on financial stability, and it is doubtful it can do so through QT, as their last attempt at reducing the balance sheet – in 2018 – has shown.
Cyclical bear market or correction?
As a result, investors are confronted with potentially very difficult outcomes. If the ‘new regime’ camp is right and the Fed delivers on its communication, there will probably be a classic stock market liquidity correction of around 10%–20%.
If, however, the second group is right and the Fed is in camp A, we are heading into a mild cyclical bear market, losing around 30% from recent record levels in the next six to 12 months.
Of course, there is always the possibility that the central bank pivots (again). In any case, it makes little sense to try and forecast the extent to which the Fed will tighten. Let us wait until the first two hikes are done and see how the system reacts.
To close on a somewhat more optimistic note, we would like to emphasise that we believe the secular bull market that started after the great financial crisis is still going on. An interrupting cyclical bear market is a typical occurrence – and we are likely to reach new all-time highs in the not too distant future.