NN IP: Central banks sticking to their guns

31 augustus 2022

With the Fed and ECB confirming their determination to keep monetary policy tight to prevent inflation expectations from getting out of control, risky assets fell further over the past week. For now, the increasing pressure on economic growth is not enough of a concern for central bankers to moderate their tightening stance.

Hawkish speeches by Fed Chair Jerome Powell and ECB Executive Board member Isabel Schnabel at the Jackson Hole summit showed once again that an easier policy stance before the end of the year is unlikely. In the US, headline inflation might moderate in the coming months, but it will probably remain too high for comfort. In the Eurozone, rising energy prices mean a peak in inflation looks some way off. Against this backdrop, our multi-asset model portfolio remains positioned for persistent inflation, more monetary tightening, rising interest rates, more negative growth surprises and increasing pressure on corporate earnings.

The Fed is looking to avoid a return to the 1970s

In the weeks leading up to the Jackson Hole summit, markets had already been stepping away from the idea that the Fed was about to become less hawkish. Several Fed governors had explained that the risk of inflation expectations deanchoring was still too high for the monetary authorities to reduce the pace of tightening.

Last Friday, Jerome Powell confirmed this message: the Fed will continue to act as if the economy is transitioning to a high-inflation regime until there is clear evidence that it is not. It wants to wait for a significant, durable and broad-based decline in inflation momentum before it considers loosening policy. What exactly this means remains unclear, but with inflation well above target and the labour market still tight, it is clear that the current Fed Funds rate of 2.5%, which is still a level that can be considered below neutral, is far from the level the Fed considers sufficient to rein in inflation. Chair Powell also stated that he expected that the restrictive policy stance would have to be maintained for some time.

The Fed’s main concern is inflation expectations. The longer inflation is well above target, the bigger the risk that inflation expectations will become deanchored. Chair Powell fears a scenario similar to the 1970s, when the Fed did not act forcefully and inflation got out of control. We continue to believe that the situation today is different from the 1970s, mainly because workers now have less bargaining power and inflation is primarily driven by supply-side constraints.

Nevertheless, the Fed wants to avoid repeating the mistake it made in 1975, when it cut rates in response to recession, even though inflation was still around 10%. Chair Powell and his colleagues are prepared to risk a near-term recession because they believe that the cumulative loss of output would be much larger if the inflation genie is allowed out of the bottle.

The hawks are also in control at the ECB

The ECB is adopting the same approach. Interest rates will probably be increased more in the Eurozone despite weak economic data and the fact that disruptions to energy supply explain most of the inflation problem. The ECB wants to do everything it can to bring inflation back under control quickly. Isabel Schnabel reiterated in Jackson Hole that inflation expectations were becoming deanchored, threatening to undermine confidence in the monetary authorities.

The question for the September policy meeting is now whether the deposit rate will be hiked by 50 bps or 75 bps, and it has become more likely that it will end the year substantially above 1%. The hawks within the Executive Board clearly have the upper hand now and they know that they do not have much time to raise rates before the economy falls into recession. Due to rapidly rising natural gas prices and very low consumer and business confidence, the probability of a deep recession has increased substantially in recent weeks.

No changes to our multi-asset model portfolio

Due to the combination of weak growth and high inflation we remain underweight in equities, real estate, fixed-income rates and corporate bonds in our multi-asset model portfolio. Ahead of Jackson Hole, we had increased our underweights in US Treasuries, Bunds and US and European investment-grade and high-yield credit. Our expectation that Chair Powell would emphasize his commitment to bring inflation back to target even at the expense of a painful economic slowdown proved correct.

More remarkable perhaps was that the ECB representatives at the summit sounded at least as hawkish. Isabel Schnabel emphasized that forceful action was needed to get inflation back under control again, while other ECB speakers floated the idea of discussing quantitative tightening at the next policy meeting. In terms of market impact, European rates responded strongly to the hawkish messages coming out of Jackson Hole. It will be interesting to see the outcome of the ECB meeting on 8 September, and whether the decisions made will be in line with recent messaging.

Credit spreads have widened in line with equity markets selling off. We continue to believe that in the current environment of elevated inflation, hawkish central banks willing to accept a significant economic slowdown and high interest-rate volatility, credit spreads will continue to widen. In our view, spreads remain too low given the global macro backdrop.

A grim outlook for earnings

In equity markets, growth stocks fell on the back of rising bond yields, whereas the energy sector escaped the sell-off thanks to rising oil and gas prices. OPEC+ comments about a possible production cut later in the year and ongoing uncertainty about Russian gas supply to Europe were the causes of energy price rises over the past week. The broad equity market struggled, mainly due to the hawkish speeches at Jackson Hole that poured cold water on some market participants’ hopes of an early dovish pivot. As a result, earnings growth rather than higher valuation multiples is likely to become the main driver of equity returns from here.

Unfortunately, the earnings outlook is not bright. Corporate margins are still close to historic highs, but they are coming under more pressure from persistently high inflation. So far, most companies have been able to pass on higher input costs to consumers and could thus protect their margins. But with inflation remaining high, input costs are likely to rise further because hedging policies need to be renewed and new wage agreements are being settled.

What’s more, companies have limited scope to continue increasing prices due to the risk of demand destruction. Some energy-intensive industries in Europe, for instance, have decided to temporarily halt production because they can no longer pass on higher production costs to their customers. Inflation is also impacting consumer purchasing power, particularly in Europe, where soaring energy bills are decimating disposable income.

Although consensus earnings estimates for next year have come down substantially to 8% in the US and 3% in the Eurozone (see figure), we think they could fall further. European earnings are most at risk due to the gas crisis and the near inevitability of a recession. In our view, this has not been sufficiently discounted by the equity markets. The 12-month forward PE for global equities is only 5% below its 10-year average. And until recently, valuation multiples were being inflated by unprecedented monetary policy support that is unlikely to be repeated any time soon – something that has become even clearer since Jackson Hole last week.