The Wrecking Ball

Currently, data which suggests the US economy is picking up momentum (as opposed to losing it) is bad news.

Yes, recession fears are rampant, which means evidence of a rapid downshift wouldn’t be welcome either, but the Fed is very keen on demonstrating fortitude in the inflation fight. Between the new dot plot and accompanying economic projections, it’s obvious the Committee intends to engineer a material slowdown. Jerome Powell is clear on that, even if he feels bad about it.

The problem for fragile markets is that evidence of economic resilience in the US emboldens the Fed, which in turn means higher US real rates and a stronger dollar. That’s bearish for risk assets, and it’s very bad news for emerging markets. Everyone can recite that narrative.

What I’ve tried to make clear over the past two weeks, though, is that in 2022, it’s not just EMs and risk assets that are at risk of imploding in the face of a determined Fed. On Thursday evening, I suggested everything might be about to “come apart.” Around 12 hours later, the pound sank to the lowest since 1985 and gilts plunged as markets recoiled at Liz Truss’s “radical” growth plan for the UK. Preliminary PMI data for Europe suggested Germany is headed for recession, and the euro dropped sharply along with European equities.

By contrast, S&P Global’s flash PMIs for the US topped expectations. At 49.2, the services gauge printed in contraction territory again, but still managed a rousing rebound from last month’s abysmal print (figure below) and beat the highest estimate from 19 economists. It was the best reading since June.

The manufacturing gauge was also ahead of estimates. A measure of factory employment rose to the highest since March.

Recall that August’s services sector PMI from S&P Global stood in stark contrast to a more upbeat read on ISM’s gauge. Friday’s flash print on the former suggests the disparity resolving in favor of ISM, although one imagines the two may find some “compromise” via a lower ISM reading for September.

Of course, 49.3 (the preliminary read on S&P Global’s composite gauge for the US in September) isn’t exactly ebullient. In fact, we just witnessed “the weakest quarter for the economy since the global financial crisis if the pandemic lockdowns of early-2020 are excluded,” as Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, noted on Friday. But moderating rates of contraction versus August, particularly in services, and the return of order book growth, should “allay some concerns about the depth of the current downturn,” Williamson went on to say, adding that “there was also better news on inflation, with supplier shortages easing to the lowest since October 2020.”

All of that’s good news. For the US. And that’s bad news for everyone else, including, ironically, US investors. Inflation is only moderating from extraordinarily high levels, and notwithstanding the likelihood that supply-side factors will ease further going forward, the recovery, especially in the services sector, suggests core inflation won’t soon fall enough to warrant any kind of rethink at the Fed.

As the pound sank and the euro dropped further below parity, the dollar surged again Friday to another fresh two-decade high (figure below).

This was among the best weeks in a decade for the greenback.

Do note: The damage isn’t just an “over there” problem. It’s a big headwind for US corporate profits. The FX drag was a hot topic during Q2 reporting season, and there’s every reason to believe it’ll feature prominently this quarter too.

In a new note, David Rosenberg called dollar strength a “wrecking ball.” Earnings, he said, are its “next victim.”

According to Rosenberg, the dollar’s influence on S&P 500 revenues is the most pronounced at nine months. That means “Q3 will really be the first time that the dollar’s rally from earlier this year will weigh on results,” he cautioned.


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12 thoughts on “The Wrecking Ball

  1. Profits tallied by U.S.-based global multinationals have been extraordinary, the best ever. They can fall some without doing much damage to the enterprises in question. A strong dollar is in the best interests of the U.S. consumer and an excellent argument in support of the greenback as the world’s reserve currency — something every American benefits from and should want to see continue.

    1. No. Just, no. It’s not that simple. At all. If this kind of dollar strength continues — i.e., inexorable, and driven by higher real rates, and Fed hikes — it will collapse entire markets and entire economies. That will boomerang back on the US. Which is why, eventually, if it doesn’t abate, the Fed and Treasury will have to do something to put the brakes on it.

      1. A rock and a hard place, for sure. That said, it would be a huge mistake, imo. for the Fed to abandon it’s rate-hiking anti-inflation campaign at home to prop up EM. The alternative probably looks a lot like the response to the GFC — swap lines, coordinated currency interventions, price controls in certain cases.

        1. In the past, the ivory tower academics at the Fed have displayed a shocking lack of understanding about how their policies impact other nations and, even worse, US business.

          This FX move is not only impacting some small EM nations, it’s hammering the rest of the world. Major and minor nations alike.

          To what end? Will higher rates boost grain and oilseed supplies? Will it increase the supply of diesel fuel used by farmers & truckers?

          The risk/reward balance is horribly skewed to the risk side.

          1. As H reminds, the rate of change is often more important than the overall amount. Has the Fed forgotten this. Inflation behaves like an ocean freighter and they don’t turn on a dime. It feels like they have talked themselves into panic mode. If that’s the case, they will definitely overshoot the mark. Inflation is a global issue as was the pandemic that caused it. The Fed ignores this at the world’s peril.

  2. In 1993, I read Trading for a Living, by Dr. Alexander Elder. He said the most neglected question in investing and trading is What is my time horizon?..It’s still rarely discussed. I would add that when someing fairly big happens, the less discussed it is the more important it is…Another question is leverage….This is directly related to the Fed. These people are human, they’re embarrassed and their goal is reputational maintainance…….

  3. I just heard that Wells Fargo and Chase will no longer underwrite HELOC (second lien) on residential real estate. That tells you what two large mortgage lenders think about residential real estate prices and it represents true credit tightening. If this keeps up, 4% could be the top for funds or maybe lower.

  4. My memory may be a bit foggy at my age but it seems that the Fed spent at least the second decade of this century trying to tune the economy to reach a target of 2% annual inflation, something I thought was stupid because systematic inflation, even at a low rate degrades asset values. A decade at 2% takes value down by 18%. Anyway, that’s somewhat moot because they didn’t manage to hit their “goal.” Now for a perfect storm of reasons we have to tamp down high inflation. If I have a leaky pipe and I call a plumber who comes to fix it and is unsuccessful, why should I hire the same guy to fix his mistake. The Fed couldn’t make inflation go up. What makes us believe they can make it go down? Anyway, it seems to me that the rhetoric surrounding our current strategy sounds more like this is all about Powell earning Street cred (pun intended) rather than solving our collective problem.

    Current events seem incongruous. The housing market is getting blasted, not a surprise, but unemployment is still low and the economy in general seems strong. There is still an apparent labor shortage. If we can beat on the economy with a huge hammer without a crushing result maybe the hammer we’re using isn’t the answer. Again, what’s all this about, channeling Volcker or stabilizing our economy?

  5. Is there any chance the Fed lays off the rate-hike gas pedal just a little–to let’s say 0.5%–at their next meeting, just a few weeks before the mid-term elections? Not for economic reasons of course, but strictly for political ones.

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