Define ‘Pivot’

This is all very simple, really.

Markets will bottom when inflation peaks and the Fed nods to the likelihood that price growth is poised to slow.

“All the inflationary bear markets in the 1960s and the 1970s followed a similar playbook,” analysts from BNP Exane wrote, in a July 26 note. Such episodes “start from a position of economic strength,” they said. “Simplistically, demand is too strong versus supply, which eventually forces the Fed to declare war against demand by creating recession.”

Jerome Powell would quibble with the notion that the Fed is attempting to engineer a recession. Indeed, he did quibble with that idea at last month’s press conference. “We’re not trying to induce a recession,” he told Bloomberg’s Matthew Boesler. “Let’s be clear about that.”

The market is pretty “clear” about it, or at least on some interpretations. One straightforward reading of the bear market in equities is that stocks got the idea the Fed was serious and re-priced accordingly, starting with valuations, which contracted in lockstep with the rise in real yields.

Note that almost everything is quite a bit cheaper these days (figure above) — on a 10-year lookback, at least. Whether equities are bargains or falling knives is a matter of opinion, and the same could be said of duration, which could return to form, hedging equity risk as growth slows, or remain a source of volatility if diversification is more dead than “resting.”

One implication is that we’re presenting distinctions without differences when we endeavor to delineate between “inflation shock,” “rates shock” and “recession shock.” The inflation shock prompted the rates shock which foretold the recession shock, and equities reflect the market’s best efforts to price the totality without knowing the depth of the recession and the impact on corporate profits.

“Once the Fed declares that it is willing to do ‘whatever it takes’ to control inflation, the market immediately assumes recession, and a vicious bear market begins to ‘price-in’ this potential recession,” BNP’s Dennis Jose, Jeremy Gaudelier and Jason Hart said, adding that PMIs and earnings only matter when contextualized via a potential Fed pivot.

During at least two previous inflationary bear markets, equities bottomed a month prior to the onset of EPS declines, they noted (figure above). They highlighted two other episodes during which it took “a few” months for stocks to trough following peak profits, but the overarching point was simple enough: “Once inflation turned, and the Fed pivoted, the market didn’t care about current earnings, and instead focused on future recovery.”

As ever, it’s about timing the pivot. But — and I’ve alluded to this on countless occasions — this pivot, whenever it comes, won’t be a hard “pivot.” Barring a 2008-style recession (which, contrary to Nouriel Roubini’s overwrought, made-for-TV prophesying, is vanishingly unlikely), the Fed won’t just stop hiking when inflation starts to turn on the way to rate cuts and the end of QT six months later. The last thing Powell wants is to declare victory over inflation prematurely.

“We think markets might be underestimating the risks of continued inflationary pressures, which might keep the central bank put far out of the money for longer,” Goldman’s Cecilia Mariotti said, adding that Goldman expects “a continuation of the hiking cycle in both Europe and the US” and is cognizant of the possibility that “earnings revisions might turn more negative.”

Again, it’ll be important for market participants to temper expectations when it comes to what counts as a “pivot.” “Will the Fed immediately cut rates if inflation next month is lower than this month? Of course not,” BNP said. “But for markets today, does a pivot necessarily need the Fed to cut? In our view no.”