Don’t Forget This Week

If you take anything away from this week’s market developments, let it be this: Central banks are well aware that their many critics are keen to lambast monetary policymakers for failing to finish the job on inflation.

Over and over again since the onset of coordinated global rate hikes, officials have insisted on their steadfast commitment to restoring price stability across the developed world. In short: Detractors doubt their resolve.

I don’t so much doubt their fortitude as I do their capacity. They’ve lost key structural disinflationary enablers to the pandemic and then to the war. The realities of strategic competition between the US and China as well as growing demands for domestic policies aimed at rectifying various manifestations of inequality in the West imply greater fiscal spending. Climate change is generally inflationary. And on and on.

Compared to the confluence of inflationary macro, geopolitical and sociological trends, policymakers’ narrow set of tools puts central banks at an almost hopeless disadvantage. They need luck, to be frank. They were very lucky for three decades, so it’s hardly surprising their luck finally ran out in the 2020s.

Policymakers are now acutely sensitive to a risk they had the luxury of ignoring for almost 40 years. All scapegoats aside, price stability is their mandate. Whether they ever had the ability to control inflation absent good luck is beside the point. They claimed they could manage inflation around a target and lawmakers tasked them with doing so. “The buck stops here,” so to speak. Again: It’s their mandate.

If inflation refuses to recede, central banks have to keep trying using the tools at their disposal even if it becomes apparent that those tools are woefully insufficient. That plainly raises the odds of a policy mistake whereby central banks are forced to tighten their respective economies into deep recessions and/or chance financial crises. The alternative — accepting higher inflation — is a total non-starter, or at least that’s what policymakers continue to insist in public.

This week, the RBA forged ahead with a second post-pause rate hike and the Bank of Canada not only raised rates after a two-meeting pause, but hinted at more hikes to come. In both cases, it’s obvious that policymakers are terrified of a scenario in which they’re blamed both for allowing inflation to get away from them, and then snatching defeat from the jaws of victory by prematurely ending their respective tightening campaigns.

If this seems repetitive, I implore readers: Don’t forget this week. It may go down as a precursor to a second leg of global monetary tightening or, at the least, as a prelude to a prolonged stay at or near terminal.

If either of those outcomes are the case, you shouldn’t expect risk assets to behave as they have around peak short rates in post-80s cycles. As Morgan Stanley’s Mike Wilson wrote, bonds may begin to price the transition, but when it comes to equity returns, there’s a “difference in performance after peak rates depending on if inflation is elevated or not.”

This isn’t new information, but it’s worth highlighting anew in light of this week’s developments. You might’ve seen the table above before, and if you haven’t, you’ve probably seen one like it. But Wilson rolled it out again, and with good reason.

In the late 1960s, 1970s and early 80s, stock returns were negative three, six, nine and 12 months following peak rates. The difference during subsequent cycles, when inflation wasn’t elevated, is night and day.

“What’s the reason for this difference?” Wilson asked. Spoiler alert: It’s inflation, and the read-through for monetary policy.

“In cycles with elevated inflation (like the one we are currently in), the Fed typically maintains restrictive policy later into the cycle because of sticky inflation pressures that persist,” Wilson reiterated. “In cycles where inflation is not historically elevated, the Fed is able to pivot earlier to a more accommodative stance — i.e., a pause and then rate cuts.”

It’s looking more and more like this will be a pause then rate hikes. Indeed, it already is Down Under and up north. I assume this is obvious, but the point isn’t that the Fed is likely to hike at next week’s meeting. The point is that a “skip then restart” is now more likely than a “pause, stop and ease.”

Wilson drove it home. “We think this is an important observation to point out,” he wrote. “The late ’60s to early ’80s may be the more analogous period when it comes to how equities behave following peak front-end rates” in 2023.

I should note that Wilson isn’t overtly bearish on equities beyond 2023. He’s ardently (and famously) bearish over the near-term (i.e., tactically), but more constructive on the outlook from 2024 forward.

I’d suggest that if our analogs are indeed prior inflationary episodes, and if central banks do prove to be especially wary of premature easing this time around to the point of purposefully over-tightening, the downside for equities could be even more pronounced than Wilson’s bear case S&P target of 3,700 for June of next year.