Illustration by Risto Avramovski
Text size
About the author: Peter Cramer is senior managing director and senior portfolio manager, insurance assets in SLC management. This comment reflects his personal opinions.
The path for risk assets in 2023 depends on how far the Federal Reserve is willing to go in its rate hikes to rein in once-in-a-generation inflation. But thinking the Fed has inflation under control today could be a painful mistake.
As we saw from overreaction to Fed Chairman Jerome Powell’s talk on Nov. 30. Investors are so caught up in anticipation of a Fed pivot that they’ve missed the more important part of his comments.
While Powell indicated in his speech that the Federal Open Market Committee would soon begin to “moderate the pace of interest rate increases,” he also said, “it is likely that the restoration of price stability will require keeping policy at a restrictive level for some time .” This is far from the pivot that bullish market participants want. He is likely to raise interest rates again by 50 basis points, or 0.5%, in December.
Fed-fund futures suggest the market believes inflation will fall enough over the next six months for the Fed to pivot to cut rates in June 2023. This type of pivot will result in a short-lived period of economic pain from high rates, followed by a return to relative normalcy in mid-2023, and would clearly be positive for risk assets.
However, the Fed may need to be even more aggressive next year to get inflation under control and push past 5% on the fed funds rate. Markets that underestimate this risk can lead to a painful correction of risk assets. There are several inflationary market forces that Powell will have to contend with.
Despite a cooling housing market, the 12- to 18-month lag between house prices and rents (which account for a third of the CPI) means shelter will be a major inflationary tailwind next year. The S&P CoreLogic Case-Shiller National Home Price Index peaked in July, giving us higher owner-equivalent rents through January 2024. And while home price increases are slowing from the current 10.6% year-over-year to 5%, e.g. historically high growth rate.
And while mass layoffs at tech companies like Twitter may give the anecdotal impression that unemployment is ticking up, the latest jobs report suggests there’s still not much slack in the U.S. labor market. Demand for labor will continue to put upward pressure on wages in 2023, which have already risen 5.1% this year, averting the significant slowdown in consumer spending needed to cool inflation.
Meanwhile, many of the disinflationary forces that helped drive the US economy to below 2% inflation over the past three decades have reversed. Indeed, globalization gave companies the opportunity to find the cheapest way to manufacture products through lower wages in developing markets. The erosion of global trust and the balkanization of trade are now creating problems in these supply chains, prompting more manufacturers to produce onshore.
The decline in global security is also driving an increase in military spending, not least because the war in Ukraine reminded Europe of the threat from Russia. Several countries in the North Atlantic Treaty Organization have pledged to increase military spending to be closer to the current target of 2% of gross domestic product, which equates to trillions of dollars in military goods and services. Defense is not a sector that scales quickly, and demand for materials and high-tech components can put additional pressure on global supply chains.
In Germany, higher energy costs from over-reliance on natural gas could bring the manufacturing industry to a standstill over the winter. The country is rapidly building liquefied natural gas infrastructure to increase its energy security, with a North Sea terminal already completed, but imports of this gas are likely to be inflationary.
Similarly, inflation will be driven by government spending plans to help soften the blow to consumers from higher energy bills over the winter. EU governments have committed more than 550 billion euros ($571 billion) to subsidize energy costs, according to economic think tank Bruegel.
If the Fed ultimately keeps interest rates higher and for longer than the market expects, it will keep its famous foot on the neck of the global economy (and risk assets), driving corporate bond spreads wider and stock values lower. Investing in this uncertain environment means protecting the downside of riskier assets. Diversify your portfolio by owning more Treasuries, sectors with more US than foreign exposures (especially municipals), or cash until the market has better priced the Fed’s actions.
The Fed may come to the realization that it needs to increase its inflation target to over 2%. If that happens, we will likely see higher rates at the long end of the curve (10 to 30 years). That will be a boon for pension plans and life insurance companies, which typically invest in longer-dated securities, but will require a dramatic repricing of long government bonds.
In the short term, don’t get carried away by the wave of optimism. The reality is that we still have a bumpy ride ahead.
Guest comments like this one are written by writers outside the Barron’s and MarketWatch newsrooms. They reflect the perspective and opinions of the authors. Submit comment suggestions and other feedback to [email protected].
