On Jerome Powell's Wish List

CIO Office National Bank Investments

National Bank Investments

Market Update │ October 2022

Highlights

• Investors endured quite a roller coaster ride in the third quarter. In closing, September saw the S&P 500 register a new low for 2022, U.S. 10-year yields test the 4% threshold for the first time since 2010, and the Greenback rise to a 37-year high.

• Clearly, this turmoil reflects markets' nervousness toward the accelerated monetary tightening carried out by central banks, and especially the Federal Reserve. So, what will it take for Jerome Powell to slow the pace, or even reduce his policy rate?

• In his own words, it will first require a period of below-potential growth, which is clearly happening. Second, labour markets must show a better balance between supply and demand, which is still far from being achieved. And finally, inflation needs to show clear evidence of declining toward 2%. In this respect, the pullback in oil prices bodes well, but core inflation measures all remain well above the Fed's target.

• In sum, all indications are that the Central Bank will continue its monetary tightening in the coming months, despite mounting recession risks. Ironically, even though the Fed is not formally projecting a recession, its own unemployment rate forecasts, if they materialize, would trigger a recession signal that has not been mistaken in 50 years.

• In the short term, an equity rebound cannot be ruled out given the level of pessimism prevailing in markets. That said, even if the Fed could hardly sound any more hawkish than it already is, conditions for a recovery are still not in place.

Market Review

Fixed Income

• The Canadian bond universe declined only slightly in September, providing some protection against significant equity market declines.

• It's a different story south of the border, where corporate bonds had their worst monthly performance since March 2020.

Equities

• September was a very difficult month for equity markets around the world. Higher than expected U.S. inflation and aggressive rate-hike projections from the Fed contributed to significant deterioration in investor sentiment. The S&P 500 finished with monthly losses of 9.2% and is now back in bear market territory.

• Once again, Canadian equities clearly outperformed the rest of the world, posting a monthly decline of 4.3%. The EAFE region and emerging markets experienced much larger drawdowns.

FX & Commodities

• Oil prices recorded their fourth consecutive monthly decline. For the quarter, the decline exceeds 25%; the price per barrel is now well below the level seen before the Russian invasion of Ukraine.

• In currencies, the U.S. dollar once again appreciated significantly in a context where the Fed is tightening its monetary policy more quickly than elsewhere around the world. The Canadian dollar, which is often positively correlated with oil prices, had a difficult month and depreciated against the Greenback.

New highs, new lows

Investors endured quite a roller coaster ride in the third quarter. After a sharp rise for equities in the first half of the period, the descent that began at the end of August accelerated in September, bringing the vast majority of assets into negative territory for a third consecutive quarter (Chart 1).

Besides, several key technical levels were crossed in recent days. On the equity front, the S&P 500 posted a new low for 2022, reaching a price last seen in November 2020 (Chart 2).

In bond markets, U.S. 10-year yields surpassed their high of last June as they tested the 4% threshold, a first since April 2010 (Chart 3).

Finally, currencies have also had their share of exceptional movement lately, with the trade-weighted U.S. dollar index reaching a 37-year high (Chart 4). Far from being a one-pair affair, the Greenback's strength was observed against all currencies, although it has been more pronounced relative to Europe (in the midst of an energy crisis) and Japan (where rates remain near zero) (Chart 5).

Why all the fuss? Clearly, these turbulences reflect markets' nervousness towards the accelerated monetary tightening carried out by central banks, and especially the Federal Reserve. Indeed, in addition to opting for a third consecutive 75-bp rate hike in September, the Fed is now projecting to stop about 100 bps higher than it had foreseen in June, i.e. at a target rate somewhere between 4.50% and 4.75% (Chart 6).

Obviously, these projections remain conditional upon the evolution of the economic environment. Yet, with only a few months separating us from these aggressive rate-hike projections, the chances of Fed officials changing their minds seem quite slim. As such, while monetary policy is not yet in restrictive territory in the eyes of markets, it probably will be before long (Chart 7).

Given this tense backdrop, it was no surprise that the first question asked of the Federal Reserve Chairman at his post-meeting press conference on September 21 was:

How will you know when to slow down these rate increases and how will you eventually know when to stop?

- Jeanna Smialek, New York Times

His answer:

First we'll want to see (1) growth continuing to run below trend, we'll want to see (2) movements in the labor market showing a return to a better balance between supply and demand, and ultimately (3) we'll want to see clear evidence that inflation is moving back down to 2%.

- Jerome Powell, Fed President

Let's take him at his word and examine each of these three points.

The three things the Fed wants to see…

On the growth front, the Fed's intended slowdown is clearly underway. After a genuine post-pandemic economic boom, U.S. real annual growth as well as the Fed's index that tries to gauge it in real time are much lower, near the potential GDP level (Chart 8).

Moreover, this observation is largely influenced by the strong growth in late 2021, while the 2022 numbers are all clearly below trend with a contraction in the first half of the year and stagnation looming for Q3 (Chart 9).

On the labour market front, the quest for a better balance between supply and demand still does not seem to be resolved. To be clear, there are improvements worth noting, such as the recovery of the participation rate for the prime-age population, which is now close to its pre-pandemic level (Chart 10). With the rising cost of living and increasingly attractive wages, one can understand why more people are looking to return to the labour market, and that's for the best.

Nevertheless, before anyone can truly speak of a labour market in equilibrium, the number of job offers per unemployed person – which recently climbed back up to a historic high (Chart 11) – will have to fall substantially. In our view, this is one of the most important economic data points to monitor in the coming months.

Ultimately, the objective behind maintaining below-potential economic growth and cooling the labour market is evidently to bring inflation down to the 2% target. In this regard, the trend in oil prices – which are about 35% below their highs of last June – continues to point to a slowdown ahead for prices in the overall consumer basket (Chart 12).

What's more, consumer surveys show a decline in expected inflation in both the short term and long term, a sign that confidence in the Fed remains in place and, thus, its battle against inflation should not be as painful as it was in the early 1980s (Chart 13).

However, after a failure to properly grasp the inflationary pressures that were building in 2021, a second miscalculation could prove fatal to the central bank's credibility. With no room to maneuver, the Fed seems determined to continue its monetary tightening until the more "fundamental" inflation measures are near 2%. There are a host of such indicators that can be monitored over different time horizons but, for now, they are all well above the 2% target (Chart 14).

By definition, this combative strategy against inflation is bound to work, but it is not without risk. Since core inflation measures generally lag the business cycle, it is basically equivalent to driving while looking primarily in the rearview mirror. Consequently, a detour into recession now seems increasingly likely.

… will likely come with a price

While the resolve of central bankers seems unshakeable at present, it will likely be put to the test in the coming months as the economic slowdown should gain traction.

Indeed, the rate hike cycle initiated by a majority of central banks roughly six months ago should begin to exert its impact on the economy more tangibly in the fourth quarter (Chart 15). This is compounded by the negative pressure on global growth brought on by the strength of the U.S. dollar (Chart 16).

Will this eventually culminate in a recession? For now, the shape of the yield curve has yet to cross the threshold that preceded each of the recessions over the past 50 years, although there is not much missing (Chart 17).

However, let's recall that since August, the Conference Board’s leading indicator has been sending a recession signal, which has never been wrong in five decades (Chart 18).

Moreover, even if the Fed does not formally forecast a recession, the reality is that its latest unemployment rate projections for 2022 and 2023, if they materialize, would also be sending a recession signal that has not been wrong in 50 years (Chart 19).

Thus, we could soon find ourselves with not one, but three recession signals with perfect track records. For the sake of discussion, using very simplistic assumptions about the yield curve signal, the unemployment rate, and their average lead time to recessions, we derive a potential recession starting in April 2023 (Chart 20).

Even so, this does not guarantee anything, as the current context is anything but conventional. Nevertheless, it does show that it’s increasingly less a question of "if" than "when."

The Bottom Line

As with every quarter’s end, we have updated our base-case scenario to reflect the changing situation. It now assigns a 50% probability to an economic stagnation scenario, followed closely by a recession scenario at 40%.

In the near term, a technical rebound cannot be ruled out, given the speed at which equity markets have fallen in recent weeks. In fact, our market sentiment indicator has reached extreme pessimism territory for the third time this year, with the last two correctly signaling a potential rebound (Chart 21).

That said, even if the Fed could hardly sound any more hawkish than it already is, we maintain the view that a sustained stock market rebound will require a downward revision of earnings growth and also, more importantly, a genuine pivot by central banks. These conditions are still not in place (Chart 22).

Bonds are becoming increasingly attractive, although the yield rise is not as significant on our side of the border (Chart 23).

In fact, this bond yield divergence between our two countries partly explains the significant depreciation of the Canadian dollar, which accelerated in September. While these movements have helped offset the losses in U.S. equities from a Canadian investor’s point of view (S&P 500’s total return in 2022 is -23.9% in USD vs. -16.7% in CAD), many wonder if there’s an opportunity to hedge against a potential rebound in the Loonie. On this matter, we continue to see the U.S. dollar, first and foremost, as a phenomenal diversifier in a world where defensive assets are becoming increasingly scarce. Consequently, it is not what we are currently recommending, although a potential deviation of 10% to 15% from our measure of intrinsic value would call for reconsideration (Chart 24).

Finally, it was mainly the movements in the U.K. financial markets that caught our attention at the end of the month. In short, the disconnect between, on the one hand, the £45-billion unfunded tax cut announced by the new Conservative administration of Liz Truss and, on the other hand, the Bank of England looking to tighten monetary conditions in order to combat inflation, caused quite a stir in the U.K. government debt market. At the worst of the debacle, the U.K. 10-year and 30-year bonds were 30% and 57% below their last highs, respectively. This is unprecedented (Chart 25).

Receiving calls to action from anxious institutional investors whose risk models are simply not calibrated for such moves – recent weekly volatility in government bonds was essentially double that seen during exceptional events such as March 2020, Brexit, or even the financial crisis (Chart 26) – the Bank of England had no choice but to urgently restart a bond-buying program to stabilize markets.

While central banks and governments were perfectly aligned in their objective of economic recovery in 2020, a fight against inflation is much more difficult to manage in a coordinated manner, and the situation in the United Kingdom is a prime, albeit extreme, example of this. Let us hope this is an isolated case that other governments will not interpret as a green light for unfunded deficits, but rather as an incentive to show some fiscal restraint until inflation is under control.