For much of the summer, markets have rallied on the idea that inflation is peaking and recession fears are overblown. While there is some truth to this notion, Fed officials have spent the last week and a half pushing back on the “Pivot” story. On Friday, Chairman Powell backed these sentiments as he doubled down on the Federal Open Market Committee’s (FOMC) commitment to fight inflation aggressively. Equity markets sold off sharply following Powell’s remarks, bringing the summer rally to a screeching halt.
It is true that inflation has most likely peaked on a nominal basis. Energy prices have softened over the summer, allowing for headline inflation numbers to ease from their June highs. Supply chains are also improving, and there is evidence that core goods prices should continue to ease in the months ahead. However, this does not mean that inflation is no longer an issue. The labor market remains exceptionally tight. Job openings continue to far outpace the number of unemployed, employees continue to switch jobs at a high rate, and the talent pool for many positions is sparse. As a result, wage pressure continues and is beginning to seep into stickier categories like services. Left unchecked, this type of inflation can prove difficult to break.
Geopolitical tension also remains a structural source of inflation. We have war instead of peace and an ongoing decoupling from the global order of the last three decades. Commodities continue to be vulnerable to shocks, and supply chains are on the move to more expensive but friendlier locations. These pressures sit outside of the Fed’s purview and are likely to persist for some time.
The Fed is keenly aware that inflation needs to come down now. In Friday’s speech, Chair Powell made special note that “the historical record cautions strongly against prematurely loosening policy.” In their view, it is better for the economy to experience some short pain vs. a long battle with inflation. The Fed Funds rate will continue to rise until it becomes restrictive. Based on this language, a recession is certainly not off the table for 2023.
In the equity markets, we have seen a subtle return to that which worked to start the year. Over the last two weeks, value once again outperformed growth. As longer interest rates resumed higher, markets returned to their preference for stocks deriving a greater portion of their value from today’s earnings. Companies sharing these earnings via dividends held up even better. A company with a consistent ability to produce and distribute cash will always be attractive.
Preston May, CBE®
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