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Dragon Breath

I figured the appropriate title for this morning’s chat over coffee should be Dragon Breath… not for its alternate morning pre-brushing meaning, as my wife quickly pointed out, but to characterize yesterday’s eight-minute speech from Fed Chairman Jerome Powell. To be fair, I also just recently watched the latest Game of Thrones spin-off, House of Dragons, which inspired me to incorporate some element in this week’s coffee chat.


For those of you that do not know, the United States Federal Reserve Chairman, Jerome Powell, spoke yesterday at the Jackson Hole conference. A conference that gathers the central bankers from around the world, as well as bankers, economists, and journalists, to discuss important economic policy. Needless to say, yesterdays historically quick speech from Jerome Powell melted markets as he quickly squashed the recent "Fed Pivot" narrative that was driving the recent bear market rally- something we’ve extensively warned about over the last six weeks.


Todays Coffee with Andrew will highlight yesterday’s key takeaways as well as reiterate our thesis for the next couple of quarters.


Last week we wrote about the recent bear market rally that was entirely driven by the assumption that the Federal Reserve will reverse monetary policy in the response of slowing economic growth. This is coined as a ‘Fed pivot". As most of you know, we have emphatically pushed back on this narrative as the Fed is dealing with inflation growth rates not seen in over 40 years. The nature of yesterday’s speech was quite impressive and starkly different from his previous speeches as he has historically catered to a balanced approach to appease financial markets. Yesterday was the exact opposite- his 1,301-word speech, lowest length for a Fed Chair since 2010, was deliberate, directly focused, straight to the point, do whatever it takes speech. Quite frankly, the only thing that pivoted was Powell’s style of communication. Below are the key takeaways from DCA’s perspective:


  • Powell gave clear warning that "pain for economy and households" lies ahead with tight monetary policy on tap for the foreseeable future.

  • Powell switched course by now saying the FOMC is against premature loosening of monetary policy which is the opposite of what he expressed in the July FOMC meeting.

  • Powell cited Paul Volcker’s efforts to quash inflation.

  • Emphatically emphasized that July’s moderation in inflation data will not deter from a prolonged policy tightening.

These powerful words from Powell’s mouth sent fire through the financial markets, which led to a meltdown in risk assets; the S&P 500 equity index finished down 3.38%, which is the fourth worst day this year.


Now, as mentioned, we are not surprised by this reaction as we have hammered the table that the Fed will not be able to pivot until inflation is well within their comfort zone. What gave credence to this opinion is the thus far resilient labor market (we do not expect this to continue- already seeing cracks) and the resurgence in energy commodity prices. Both inputs have high impact to the Fed’s inflation measures. The proof also began displaying in financial markets as interest breakevens (measure of inflation) have creeped higher since mid-July.


While it is unpopular to say, The Feds current mandate is to slow economic growth to a point that causes BOTH higher unemployment and reduced demand to a point that slows inflation, a mandate that market participants haven’t experienced since Greenspan (20 years). And although the Fed is a path of slowing economic conditions, we must remember that this policy approach is necessary ingredient to a sustainable business cycle. The cyclical behavior of inflation influences the policy standards for the cost of money. This function helps reduce excesses in the financial system such as home prices that reached 99th percentiles or income disparities that have led to divisive policy actions. This alone is why we argue that the Federal Reserve (any major Central Bank) is one of the most important, if not the most, players to watch to understand the path of modern financial markets. The chart below shows the path of the global business cycle.


As the slowing of economic data manifests itself within the economic engine, we believe the next leg of this slowing business cycle will be a rise in unemployment data as companies reconfigure margin structures in the event of lower profits from higher borrowing costs and labor costs. Once the unemployment data rises, we will begin to see a durable pivot in monetary policy that will catalyze upward inflection in the business cycle. As stated last week, given how quickly this has unfolded, we expect this cycle to flush through at a much faster pace than we have seen in previous cycles.


In response, we have maintained elevated cash weights, and defensive growth tilts to reduce relative drawdowns. Although there is a bit more wood to chop regarding the business cycle, as mentioned above, yesterday’s fiery tone from Jerome Powell is the step in the right direction toward a trough in the cycle. We are watching the data closely. Please do not hesitate to contact me with any questions or comments. Best, Andrew H. Smith Chief Investment Strategist


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