US inflation risk, angry bondholders, and silver linings

Juhi Dhawan, PhD, Macro Strategist
2022-08-31
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Here are quick thoughts on some common questions I’ve been asked recently about Fed policy, yields, the US dollar, and financial markets.

Why is the Fed doing what it’s doing if a recession could be the result?

The Fed’s mandate is full employment and inflation. It has achieved the first of these objectives but is woefully behind on the second. The so-called “Fed put” for markets worked when inflation was low (the paradigm for the last 30 years), but when inflation is high and unemployment low, the Fed will turn a blind eye to equity market declines as it seeks to protect Main Street rather than Wall Street. Of course, everything changes if there is systemic risk. To regain credibility with angry bondholders, the Fed must be willing to accept a growth penalty in the current situation.

Do you think we’re approaching the peak in yields?

Before reaching that conclusion, I would like to see inflation expectations peak. They may have already, but given energy concerns in Europe and supply-chain bottleneck issues in China, inflation may still have a last hurrah. Also, the US depends on the generosity of strangers to fund its budget deficit, and the Fed’s moves certainly have some bondholders thinking about what to do with their allocations. This matters because yields are a function of growth and inflation but also of the demand for and supply of bonds. In a world of low inflation, many countries were willing to fund the US deficits. Now, with a Fed that wishes to unload bonds from its balance sheet and currencies like the yen weakening, we must wait and see the response of these players before assuming yields have peaked, even with the expectation of weaker growth.

Why is the US dollar strong?

It’s because of the difference in interest rate policies being determined by the Fed and the other central banks. The European Central Bank is slowly going to follow the Fed, while Japan has doubled down on yield-curve control and China is now actively easing. I would expect the US dollar to peak as interest rate expectations in other nations lift and/or Fed expectations get priced in and US growth slows. For what it’s worth, the US dollar often peaks around the first rate hike; that hasn’t been the case this time around due to conditions elsewhere, but over time I do expect some relief here.

How do current conditions impact your view on value vs growth?

While inflation is the arbiter that gave value a leg up (energy in particular), it is also the concurrent reaction from the Fed to raise the real rate that penalizes growth stocks. A peak in the real rate and lower nominal growth should help make growth attractive again.

What about cyclical stocks?

Positive catalysts for earnings would be a softer US dollar, a bottoming in industrial activity globally, and a peak in commodity prices, which would give a lift to many consumer and industrial companies that have been under siege.

Are there any silver linings?

Yes! The private sector balance sheets on both the consumer and corporate sides were in good shape coming into the year. Inflation is poised to move lower; while it will take time to get to the 2% target, it is starting to turn. Both Europe and China are facing event-driven downturns; these tend to be deep but quicker to turn. And, as noted, China is now easing, which should lift global growth later this year.

From an investment opportunity perspective, what are some of the themes you are focused on?

Services over goods consumption is one. Another is beneficiaries of supply-chain improvements in the business and consumer space; here I expect better trends in the second half of this year. With the Russia/Ukraine conflict, there is also renewed demand for energy and agricultural exports from the US. I also see opportunities related to workforce development and education, as well as other areas where there is a relative scarcity of labor, including automation and innovation.

I also think it’s worth looking for opportunities outside the US, where markets are cheaper and recessions are already priced in. Many markets tightened earlier and have the space and ability to ease. I’m also looking at the theme of a capital spending cycle, especially if the current rhetoric from Treasury Secretary Janet Yellen about “friend shoring” holds. This could create opportunities among supply-chain beneficiaries in ASEAN countries, Mexico, and countries with commodity assets.

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