Pivot is the Wrong Word
Peak tightening, fiscal folly, real, not nominal, contraction, monetarism and the shoe that didn't drop
Peak Tightening Expectations
It will ‘likely be appropriate to slow increases at some point’
Forward guidance is done, at least for now
The front-loading process is complete
Two important themes came together this week. First, the Fed completed the ‘front-loading’ process, confirming the critical inflection point for markets, peak tightening expectations, occurred at the June FOMC meeting. Like the November ‘94 75bp hike, the FOMC’s 11th hour decision to hike 75bp in June created the conditions for the ‘22 Fed policy tightening low in the equities market. There was a plethora of evidence prior to the June FOMC meeting that inflation was peaking, however equities couldn’t stabilize until the Fed confirmed that policy was turning data dependent. Pivot is an inappropriate characterization of the Fed’s policy stance, and although forward guidance has thankfully been scrapped, the Fed is still likely to continue hiking their policy rate. We have 25bp at each of three remaining 2022 meetings penciled in based on our expectations that the two rounds of inflation, housing and labor market data prior to the September 21 FOMC meeting will soften.
The second theme was our nuanced view of the highly political recession debate. For equity investors, a contraction in real growth accompanied by continued expansion in nominal output implies more resilient earnings growth than a bank credit financed malinvestment bust like commercial real estate in ‘91, telecom and technology in ‘01 and residential real estate in ‘08. 2Q earnings tracking 8%, revenues 12%, a 0.9% contraction in real 2Q22 GDP, and nominal output increasing 7.8% was consistent with our outlook for a real, but not nominal, economic contraction. The first estimate of gross domestic income will have to wait until next month’s revision, however with corporate earnings growing close to 10% and labor income (average hourly earnings times hours worked) increasing 10.6% in 2Q22, we suspect nominal gross domestic income grew robustly and real income expanded. The stage is set for the equity market to reverse in 2H the losses from 1H as inflation falls towards our 2023 4% forecast. We got out of the S&P 500 price target business when we resigned as Barclays Head of Equity Strategy in 2014, however we did provide a 4900 year-end 2022 forecast to the CNBC Fed Survey. While equities, and cyclical sectors in particular are attractive, the Treasury market looks exceptionally overvalued, and we suggest fading market expectations of rate cuts in 2023.