Late last year, as the market was busy aggressively pricing out Fed hikes amid a truly nauseating swoon in risk assets, one worry was that if Jerome Powell were to change course and expressly acknowledge nascent signs of weakness in the data and/or suggest that the tightening in financial conditions occasioned by the pullback in stocks posed a material threat to the economy, he might actually make things worse.
Clearly, the market was nervous and the “imminent slowdown” narrative was gathering adherents – fast. At a certain point, souring sentiment and falling stock prices can become self-fulfilling if they begin to manifest themselves in real economic outcomes (e.g., the reversal of the wealth effect denting consumer spending, corporate management teams reassessing capex plans, etc.) which are then cited as an excuse for still more selling, in a pernicious loop.
The risk was that if the Fed suddenly lurched dovish, it would be seen by the market as “confirmation” of the slowdown story, thereby denting sentiment further. In the worst case scenario, an overtly dovish lean had the potential to underscore the notion that the Fed believed it had already made a policy mistake by tightening the economy into a slowdown.
You could argue that by holding out until January before “capitulating“, “blinking” and otherwise relenting in the interest of reinvigorating risk assets, the Fed mitigated the risk outlined above. If that’s the case, it may have been by accident given that the December minutes pretty clearly suggested the committee was inclined to adopting a more accommodative tone than Powell managed to communicate on December 19.
Whatever the case, the question now is whether there’s any gas left in the tank in terms of dovishness that could offset another leg lower for stocks, another leg wider in credit or just another bout of volatility in general.
Clearly, the Fed has more room than its global counterparts when it comes to rates and the balance sheet. In the simplest possible terms, the Fed actually has the capacity to cut rates from here, whereas doing so in other locales would entail plunging into deeply negative territory. On the balance sheet, the Fed can lean dovish by doing something as simple as announcing an end date.
So, there’s clearly scope for the Fed to do more when it comes to “incremental” dovishness in the face a worsening macro backdrop. For Morgan Stanley’s Mike Wilson, though, there’s a simple reason why that probably won’t work when it comes to rescuing equities in the face of the earnings recession he says is already upon us.
On Monday, we brought you some highlights from Wilson’s latest note, in which he flags consensus expectations for negative profit growth in Q1 on the way to contending that his earnings recession call from November is all but certain to play out.
In the same note, Wilson warns that you probably should “not expect the Fed to be a savior when it comes to earnings headwinds.”
As noted above, Mike’s rationale is straightforward. “The market has already priced in a lot of Fed dovishness and incremental dovishness from these levels is going to require data deteriorating which will not be a good environment for equities”, he writes.
Now you can see why we started this post with a trip down memory lane to December. This is the same quandary for stocks. Sure, it’s possible that the Fed will step in with more dovishness, but given Powell’s hyper-data-dependence and the fact that January’s relent was as dramatic as it was, any further lean in the direction of accommodation would likely require a sharp deceleration in the economy. Acknowledging such a deceleration with a rate cut or a halt to balance sheet runoff would effectively amount to confirmation of a slowdown, potentially making things worse.
If, on the other hand, the data starts to improve, you can expect less dovishness and that’s not exactly positive for stocks either, especially if earnings growth ends up disappointing. Here’s Wilson one more time to bring it all together:
We think Exhibit 8 makes this point powerfully by showing the huge separation between expectations for rate moves and economic surprise indices. We expect these series will move toward converging, and whether that is due to dovish expectations falling out of the market or economic surprises turning lower, we suspect that neither is a bullish signal for equities.
Again, it doesn’t get much simpler than that, so if you’re the type who thinks there’s elegance in simplicity, that’s a pretty elegant (if bearish) thesis.