News in Charts: Market takeaways on inflation and hawkishness

The markets have been struggling to find anything good in the recent data releases or global developments. Their behaviour is largely guided by the next inflation print and whether the announced number of interest rate hikes continues to seem necessary or even conservative.

With certainty at a premium, in this article Fathom lays out the conditions that could trigger a recession, and the ways that that can be avoided.

The immediate background to today’s uncertain picture is the response of policymakers to the COVID pandemic. The ultra-loose fiscal and monetary policy mix has got economies back on their feet, but at the cost of higher inflation. In its Global Outlook, Summer 2022, Fathom outlined how consumers and the markets were coming to grips with sticky inflation, and how the repercussions could trigger a recession. Falling household real incomes could weaken consumption in the near term; and even if that were avoided, aggressive monetary tightening could push us into recession further down the line. Looking at the prospects for avoiding recession, Fathom argues that countries where households have a large stock of excess pandemic-related savings to draw on are in a stronger position to avoid a consumption collapse. As for the second potential trigger, a restored faith in central banks and their inflation targets might mean that policymakers would not need to slam on the brakes. We believe that the US, with higher excess savings and lower reliance on Russian gas, is better placed to avoid consumer-led inflation than the euro area. The credibility status of central banks remains to be seen.

One of the greatest reasons for pessimism on inflation has been that consumers seem increasingly to expect it to last, something that Fathom has been flagging as a risk for a while. The University of Michigan’s surveys of consumers show that US consumer expectations for inflation 5-10 years from now jumped to 3.3% in June, from 3.0% in May. The same surveys show consumer confidence at lows that haven’t been experienced since the GFC and the 2011 “Fiscal Cliff”.

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Soaring inflation has hit consumer confidence, suggesting a consumer-led slowdown could already be under way. That prospect is increasingly being reflected in the outlook for corporate margins. The Chicago Fed’s Purchasing Managers’ Index (PMI) leads corporate margins by approximately six months, and the latest figures suggest company fundamentals are poised to deteriorate significantly. Corporate margins are likely to be squeezed by weaker consumption and by rising production and supply costs.

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Against this backdrop, the markets could only pivot towards a more pessimistic view of the economy. The yield curve is now almost flat from two to ten years. Were the slope to turn negative, then experience suggests a recession could be just around the corner. Investors are becoming increasingly convinced that the Fed will need to tighten until something in the economy snaps.

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This growing realisation has sent the returns of risky assets, including equities, into negative territory. There is evidence that we may be witnessing the start of a fierce competition between equities and fixed income for investors’ money, from which equities frequently emerge the loser. Stocks have had an exceptionally good run, particularly during the past two years when the liquidity wall provided by the Fed was looking for a home. Expectations of sticky inflation, and what that meant for the fed funds rate, has made the so-called ‘risk-free’ US sovereign fixed income attractive again. That can be seen in the performance of the ETF that tracks the S&P 500 relative to the ETF that tracks the 20+ year treasury bond, which just broke below its 200-day moving average. Does this represent a surge towards fixed income? Not yet. It appeared to happen once before in 2022, but only temporarily; however, the conditions now may be more welcoming.

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Higher policy rates have a particularly bad impact on long-duration stocks, such as technology stocks, which have most of their values attached to the future. Given their back-end-loaded values, the prices of technology stocks are sensitive to upward discount rate shocks, proxied by the yields of long duration bonds. Nasdaq, the ‘home’ of tech, suffered this quarter, along with all other technology indices, and this may continue if it appears the Fed is persisting in its focus on fighting inflation by hiking rates.

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The ramifications of central bank hawkishness over battling inflation have been most serious in the euro area, which faces the additional problems of concern about the financial stability of the periphery countries, lower excess savings and heavy reliance on Russian gas. The European Central Bank (ECB) faces a stark choice. It can hike rates now to prevent second round effects on inflation, but at the risk of driving bond yields higher in the euro periphery, something that the recent announcement of an intention to hike prompted; or it can maintain relatively loose policy, but at the risk of de-anchored expectations.

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