Investors can be forgiven for feeling they are in a holding pattern, like an aircraft waiting to land and begin a new flight. We are waiting for the rising inflation and weakening demand to pass and for a new economic cycle to begin.
This week’s mid-term elections for Congress and the release of November’s CPI inflation data may have helped hasten the descent out of the holding pattern, at least for investors in US assets.
At publication of this market commentary, the Democrats are likely to (just) hold onto the Senate while Republicans have taken control of the House of Representatives.
It is perhaps hoped that because the ‘red wave’ turned out to be more of a splash, with candidates backed by Donald Trump performing worse than expected, we may see an improvement in cooperation between the two parties.
Mainstream Republicans may feel less obliged to follow the line taken by their more Trumpian colleagues and may wish to position themselves as moderates. Democrats will have a strong incentive to work with them next spring when the debt ceiling has to be increased again.
Mid-terms and the markets
It’s a cliché but based on the fact that Wall Street likes stalemate in Washington. Particularly if the scenario is of Republicans putting the breaks on business tax hikes. Bloomberg recently cited a study by broker-dealer LPL Financial that used data from 1951 to show that -on average- a Democratic president with a Republican, or split, Congress saw much stronger returns on the S&P500.
Not only are business tax hikes now on hold, but so will any new spending program. This is good news for bond markets since the fiscal stimulus programs of recent years are perhaps a significant factor behind America’s current inflation problem.
The Democrats have firmly shaken the money tree over the last year. The impact will shore up household and business demand and hinder the return to the Fed’s 2% inflation target.
Hence that sense we might have, as investors, of being in a holding pattern. The Fed wants to engineer a downturn to reduce employment, create slack in the economy, and ease inflation. While Democrat-controlled Congress looked for ways to minimise the effects of inflation on incomes.
The numbers are staggering: Joe Biden’s infrastructure bill contains $550bn in new spending, and the CHIPS act -passed in July- has $50bn of new spending. The Inflation Reduction Act has $485 in clean air and health prescription subsidies (although offset by tax increases over the first five years). The student loan forgiveness program may cost as much as $400bn.
Those days are over.
The November inflation data
This brings us to the recent CPI inflation data, which showed a year-on-year deceleration of headline CPI in November to 7.7%, while core inflation fell to 6.3%. The latter will be particularly pleasing to the Fed and investors.
Energy and food price inflation can be expected to roll over as supply shocks ease (and year-on-year data rolls over) and has never bothered central banks. But core inflation, which excludes food and energy, risked becoming entrenched.
Higher borrowing costs appear to ease demand for employment, which should limit wage growth. One suspects that the wakening housing market dampens confidence and spending in the economy.
How might Fed policy be affected?
With the headline and core inflation now on a downward trajectory, the days of 75bps rate hikes from the Fed may be over. A 50bps rate hike at its next meeting, on December 14, is now expected. This would align with the outlook for rates it gave last week, of smaller increases but going on into next spring rather than ending at Christmas.
It seems likely that US interest rates will peak at around 5% during the spring/summer of 2023, from today’s target rate of 3.75% – 4%. We can expect a pause before an easing cycle starts later next year.
As the easing cycle begins, the type and extent of the emerging investment opportunities will largely depend on how much demand is left in the economy after the Fed has squeezed out unemployment. Fortunately for the US economy, the Fed’s policy of tough love is taking place at a time of near-full employment, and it is hoped that inflation can be tamed without too much permanent damage done to the labour market.
In summary, a runway to land on is visible. Further fiscal stimuli from Congress to prop up growth, which will hinder the Fed’s war on inflation, is difficult to conceive. Meanwhile, the welcome drop in core inflation will reassure investors that its war on inflation bears fruit.
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