About the Author: Pierre Cramer is Senior Managing Director and Senior Portfolio Manager, Insurance Asset Management at SLC management. This comment reflects his personal opinions.
The trajectory of risky assets in 2023 depends on how far the Federal Reserve is willing to go with its interest rate hikes to contain the inflation that only happens once in a generation. But believing that the Fed is controlling inflation today could be a painful mistake.
As we saw in the overreaction to Fed Chairman Jerome Powell’s November 30 speech, investors are so caught up in anticipation of a Fed pivot that they’ve overlooked the hardest part. important to his comments.
While Powell indicated in his speech that the Federal Open Market Committee would soon begin to “moderate the pace of rate hikes”, he also said “it is likely that restoring price stability will require maintaining policy at a restrictive level for a period of time”. This is a far cry from the pivot bull market players want. It will likely raise rates again by 50 basis points, or 0.5%, in December.
Fed funds futures suggest that the market thinks inflation will fall enough over the next six months to allow the Fed to pivot to lower rates by June 2023. This type of pivot would result in a short period of economic difficulties from high rates, followed by a return to relative normality by mid-2023, and would clearly be favorable for risky assets.
However, the Fed may need to be even more aggressive next year to rein in inflation, topping the 5% fed funds rate. Markets underestimating this risk could lead to a painful correction in risky assets. Powell will have to contend with several inflationary market forces.
Despite a declining housing market, the 12-18 month lag between house prices and rents (which account for a third of the consumer price index) means housing will be a major driver of inflation next year. The S&P CoreLogic Case-Shiller National Home Price Index peaked in July, giving us higher owner-equivalent rent through January 2024. And even as home prices slowly rise from 10.6% yoy annual at 5%, for example, a historically high growth rate.
And while massive layoffs at tech companies like Twitter may give the anecdotal impression that unemployment is rising, the latest jobs report suggests there’s still not much slack in the US labor market. Demand for labor will continue to put upward pressure on wages in 2023, which have already risen 5.1% this year, avoiding the significant slowdown in consumer spending needed to calm inflation .
Meanwhile, many of the disinflationary forces that helped propel the US economy to below 2% inflation over the past three decades have reversed. Namely, globalization has allowed companies to find the cheapest way to produce products through lower wages in developing markets. The erosion of global trust and the balkanization of trade are now causing problems in these supply chains, prompting more manufacturers to produce onshore.
Declining global security is also leading to increased military spending, not least because the war in Ukraine has reminded Europe of the threat from Russia. Several North Atlantic Treaty Organization countries have pledged to increase military spending to approach the current target of 2% of gross domestic product, equivalent to trillions of dollars for goods and services military. Defense is not a fast-moving industry, and the demand for high-tech materials and components could put additional pressure on global supply chains.
In Germany, rising energy costs due to an overreliance on natural gas could cause its manufacturing industry to stagnate during the winter. The country is rapidly building liquefied natural gas infrastructure to increase its energy security, with a terminal in the North Sea already completed, but importing this gas is likely to be inflationary.
Likewise, inflation will be fueled by government spending plans to help soften the blow to consumers from higher energy bills over the winter. European Union governments have committed more than 550 billion euros ($571 billion) to subsidize energy costs, according to economic think tank Bruegel.
If the Fed ultimately keeps rates higher and longer than market expected, it will keep the proverbial foot on the throat of the global economy (and risky assets), driving corporate bond yield spreads. wider and lower stock market values. Investing in this uncertain environment means protecting yourself against the fall in the riskiest assets. Diversify your portfolio by holding more Treasuries, sectors with more US exposure than overseas (especially municipalities), or cash until the market has better gauged the moves from the Fed.
The Fed may realize that it needs to raise its inflation target above 2%. If this happens, then we are likely to see higher rates in the long end of the curve (10 to 30 years). This will be a boon for pension plans and life insurance companies that typically invest in longer-dated securities but will require a dramatic repricing of long-term Treasury yields.
In the short term, don’t get carried away by the wave of optimism. The reality is that we still have a bumpy ride ahead.
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