“Fool Me Once, Shame on You; Fool me Twice, Shame on Me”
“Fool Me Once, Shame on You; Fool me Twice, Shame on Me”
Investment Allocation Thesis Based on Federal Reserve Strategy and Economic Indicators
By Emil Kyulev
The Federal Reserve has progressively stepped up its rhetoric on the duration of a high-interest rate economic environment in the US. This paradigm stemmed from two consecutive years of inflation surprising to the upside; an objectively catastrophic misjudgment from the Fed took place as they coined the term “transitory inflation” to ease market concerns. We now find ourselves in a polarized time, with opposing schools of thought regarding the short-medium term global economic outlook. This essay will focus on the Fed’s expected behavior, recession overview and the overall stock market valuation.
Complexity of Federal Reserve Decisions
Altough investors might consider relying on leading indicators to determine their asset allocations, the psychology of the Fed must also be considered, as it is not always rational. Given the public mistake of not increasing interest rates following the period of QE and inflation indicators lighting up, the Federal Reserve was on the receiving end of significant backlash. After all, their mandate’s primary purpose is to control inflation before all other undertakings. Having gone through this experience, it is unlikely that the Fed will risk making the same mistake twice by underappreciating the inflationary environment and keeping interest rates low. Whilst the market might consider recent improvements in inflation numbers as a clear sign of imminent reduction in interest rates, I believe the Fed will take their time before shifting from the hiking strategy. It is understood that this action would threaten hiking the economy into recession, but perhaps this is what the underlying strategy truly is. The Fed would prefer to come out of this looking like an objectively entity that mitigates inflation risks through conservative actions, rather than risk the repeat of last year’s reputational damage.
Stock Market Remains Very Expensive
A very interesting indicator to observe is the ratio of GDP to the NYSE index; what becomes clear is that despite the recent corrections in the market following the rise in interest rates, we are still at historically expensive levels. This is the highest level in nearly sixty years.
Uncertainty Surrounding Consumer Confidence
There is conflicting data surrounding the overall assessment of consumer confidence. The Overall Consumer Confidence Index is currently 5% below the pandemic average, a very concerning notion regarding spending in the economy.
Inflation — Recession Relationship
The recent inflation data recently moderated to 7.7%, beating highest-probability expectations.
This resulted in a rally of the stock market; the enthusiasm primarily based on the increased probability of a smaller Federal Reserve interest rate hike of 50 basis points. This notion was supported by Christopher Waller, Federal Reserve Governor. I believe this stabilization of inflation in the US is linked to the lower consumer confidence; recession is the most effective way to kill inflation in an economy.
Beyond the simple time-series analysis of numerical inflation data, let’s consider something deeper. What is causing this inflation? Commodity prices have remained high, and this has a lasting impact on supply-side inflation as different parts of the supply-chain take time to adapt to their new increased costs. This price will eventually be reflected on the consumers, but this does not happen immediately. We are seeing it happen now. On the other side of the coin, demand-induced inflation has been decreasing due to lower consumer confidence and higher incentives to save. These two opposing forces have been at war ever since the interest hikes came into play; and it seems that the consumer-demand is starting to win out as inflation begins to stabilize. Higher costs of production with a lower consumer demand are not a good indicator of future economic activity.
The identification of a recession is easy when looking back, but very difficult when in the middle of one. We have seen two consecutive negative GDP quarters this year followed by a Q3 growth of 2%; the expected Q4 data is a moderate 0.4% growth. I believe we are very likely already in a recession; the market forces have begun moving and we cannot stop them until they lose all inertia carried into next year. Leading indicators show us that consumer demand, economic sentiment is very low.
Yield Curve Inversion
In economic academia, one of the most widely accepted leading indicators of recession is the inversion of the yield curve. It measures the yield of bonds across different maturities; normally the long-term bonds should offer a higher yield. If short-term bonds have higher yields, this shows us just how desperate corporations are for funds, which tends to happen in recessionary times.
The shaded rectangles represent historical recessions. Notice how each time the spread between the long-term treasury bond (10Y) and the short-term treasury bond goes negative, a recession is set to follow. The predicting ability of this indicator is truly remarkable. Unfortunately, its predictive powers might come true sooner than we were hoping for, as we have just seen another inversion on November 18th. From the looks of it, this seems to be a longer recession than we experienced during COVID. Of course, yield curves are subjective in the sense of what maturities are compared.
Timing the Bottom
While most might agree with a negative outlook on equities in the short-medium term future, the timing of the bottoming and reversal is quite a polarizing topic. Since the market tends to anticipate events and price them in accordingly, the bottoming out may occur way before we see the first reduction of interest rates. Historically, what we have seen is that the bottoming out occurs around two-thirds of the way into the recession, in fact this has happened on almost every occasion. I expect this to occur somewhere around Q2-Q3 of 2023.