During our Coffee with Andrew today, I wanted to briefly discuss what seems to be a relentless expectation that the Fed will give us a pivot based solely on the recent volatility. And to be fair, the expectations are understandable as investors have been conditioned with recency bias that the Fed will save the day as they have done over the last 15 years; pivot when the times get tough. This note today is a quick dive into why the Fed has No Trick to save the day, thus providing us No Treat in the form of a risk asset rally. Something the "buy-the-dippers" and "bottom-callers" have been painfully reminded of. Enjoy!
It goes without saying that this has been one of the worst markets for both bond and equity investors alike in decades. We have seen historic cross-asset volatility and drawdowns that many haven’t experienced in decades. I will be the first to tell you that no bear market is fun. I will also be the first to tell you that bear markets are a normal outcome and necessary ingredient for business cycle conditions, something that seems to be forgotten as many have pounded the table for a Fed pivot. Over the last eight weeks, it has been quite remarkable to see financial, social media contributors, journal articles, and fellow market participants hammering the table for a Fed pivot, citing the recent slowdown in housing and cross-asset volatility as a viable justification. The chart below shows the number of the story counts for a ‘Fed Pivot" over the last 10 years.
It goes without question that housing prices, equities, and bonds have experienced a dramatic revaluation as the Fed clearly missed the boat on the persistent inflation backdrop that was emerging, something we have been hammering the table on for well over a year. Now in 2022 we are seeing the effects of the Fed quickly reversing course which alone has been enough to reverberate through the global financial markets. Bear markets are painful and by no means am I dismissing the shock value of this drawdown but to be fair I find the argument of a Fed pivot based on recent capital market dynamics quite misguided. One of the most stated excuses for a Fed pivot is the recent slowdown in housing. We at DCA have highlighted how important housing is as an early-cycle economic indicator, given its multiplier effect through the economic engine. And yes, while housing activity/sentiment experienced an abrupt halt, I find it bewildering that many argue for a Fed pivot amidst the recent (relatively marginal) price decline. It is interesting that no one complained when house prices grew 20% at a compounded annual rate post covid, a growth rate well above trend per the chart below.
The same trend line analysis can be done with equity markets (specifically NASDAQ), fixed income, private equity, and crypto. All of which enjoyed their day in the sun following extraordinary monetary easing not only post covid but in the aftermath of the global financial crisis. So, yes, the market declines experienced so far this year are eye-opening but should be put in the context of recent history, specifically the above average annual returns over the last two years relative to capital market history.
What we have been postulating at DCA is that while capital markets re-value, the true data to look at for a Fed pivot is the labor market which is still growing above pre-covid trend rates which in of itself manifests higher core inflation; Private Payrolls at a 3-month annualized rate sits at 3.5% which is above the 2015-2019 average of 1.7%; Private Sector Aggregate Income at a 3-month annualized rate sits at 7.6% vs 2015-2019 average of 4.4%. Labor growth rates at these levels continue to keep core inflation above the Fed comfort zone of less then 3%. The chart below shows the latest annualized growth rates for Core PCE relative to Federal Funds Rate.
As we’ve mentioned in previous Coffee with Andrew sessions is that true deterioration in employment data will lead way to decelerating inflation which will finalize a Fed pivot in the form of a pause or rate cut. Our aim today is to re-condition the thought process that the Fed is hyper focused on labor data rather than price declines in financial assets. And while the declines financial assets have been painful to experience, as they always are, the Fed knows that markets have not come close to pricing risk as they have in the past. The chart below shows the Junk Bond Market, Yield to Worst, spread over 10-year Treasury yields. While the spread has steepened, it has yet to hit levels associated with market disfunction.
We are at the juncture in the cycle where good news such as resilient labor data is treated as bad news given the Feds reaction function which typically falls in the latter innings of a slowdown. The final phase of cyclical slowdowns is a slew of profit cuts accompanied by rising unemployment. Therefore the DCA playbook for a Fed pivot is not the volatility of assets but the destruction of labor as the Fed has stated they welcome higher unemployment rates.
We continue to maintain elevated cash weights and defensive growth tilts to reduce relative drawdowns. We are monitoring employment data closely as well as financial assets that price structural risk within the economy. At this juncture, the current state of employment has kept the US economy resilient, but we expect that to change in the coming months which will drive us closer to the ultimate Fed pivot.
More to come in the upcoming Quarterly Reflection.
Please do not hesitate to contact me with any questions or comments.
Andrew H. Smith
Chief Investment Strategist
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