Market Timing
Federal Reserve Inflation Fighting or a Federal Reserve Pivot; is likely the biggest market debate right now.
August 2022 CPI data are scheduled to be released on September 13, 2022, at 8:30 A.M. Eastern Time. When this data point comes out we will get another clue on the trajectory of inflation. Recently, inflation stopped accelerating higher. So this data point is particularly valuable because it has the potential to confirm a down trend in the rate of change of inflation. If the inflation rate is lower than July’s 8.5%, a downtrend will be in place. This could lead market participants to price into stocks that the Fed will ease off of the current rate hike trajectory. Market participants’ fears that the Fed will hike the economy into a painful recession would be diminished. This in turn could take away the concern of a decline in corporate profits and thereby reduce the risk of layoffs that could reflexively produce deflationary forces, which take asset prices (stocks, houses) lower.
One of the cornerstones of this debate, “Fighting inflation or a Federal Reserve Pivot”, is the Fed’s 2% inflation target. Are they going to change the target? My personal perception is that they will abandon the 2% target. I think it is easy to see that the Fed, and policy makers broadly, will change the rules of the game when it is necessary.
What makes it necessary to change the rules of the game? Pain. And right now there is not a lot of evidence of pain, in the data. We can see the beginnings of pain (ISM PMI downtrend, New Homes Permits slowdown, Layoffs rate of change rising, Financial Conditions had been tightening) however the pain is not acute. Sure, the psychological component had become front and center. Recession talk and Armageddon talk around Europe was pervasive, yet most households continue to earn wages, they feed their 401(k) target date funds, they service their debts, and mortgage rates are below inflation (so debtors are getting paid to borrow money).
I am forecasting that the Fed will signal a pivot, that they will also signal a change away from the 2% inflation rate; But not yet. We need a bit more economic turbulence, a bit more weakness in asset prices before the Fed has sufficient political cover to make the Pivot; The weakness will likely take a least another 90 days to show itself.
The major risks to my forecast include timing, fiscal policy and a lack of clarity around political dynamics. If fiscal policy continues to accelerate, there could be enough credit growth to sustain economic activity and corporate profits. Political dynamics drive fiscal policy, so these are one in the same from a financial perspective. Regarding timing, I believe the noisy environment has shortened the markets forward looking posture. Perhaps the market usually attempts to price in outcomes 6-12 months into the future, however, I believe that the noise and complexity has compressed its outlook to less than 6 months.
The tail winds to my forecast, or the clues that the more pain needed before a pivot thesis is correct, would include: August CPI data point does not accelerate to the downside, Fed speakers do not guide to a change in the 2% target, No material change in employment.
If these conditions are met, I believe the market will think the Fed is likely to remain hawkish and this will facilitate a failure of the SP500 to break out above its August high, then it will move down to ~3,300 as a second wave of deflation fears mount.
A market shock (something like the 2018 repo spike) or an unexpected geopolitical escalation could accelerate the timeframe for my forecast.
This blog post is a thought experiment, to which I can refer back, to try and understand near term market action. Its purpose is not to guide timing activity, but instead to help set expectations and help to assess the probabilities. Enjoy!
