Although recent US data has been favorable in terms of resilient growth and softer inflation, we think it’s still too early to give much consideration to a Fed pivot. These recent economic trends may not be sustained over the medium term, and given this uncertainty we believe investors should continue to build resilience into their portfolios, including seeking downside protection.
CIO thinks the current economic outlook is still too uncertain for the Fed to pivot policy, as the recent encouraging trends in the data may not be sustained over the medium term. (ddp)
US economic data for July has been encouraging. The ISM Manufacturing PMI edged down to 52.8 from 53 in June while services PMI rebounded to 56.7 from 55.3. Nonfarm payrolls beat consensus by a wide margin to increase by 528,000, and the unemployment rate fell to 3.5%, matching the pre-pandemic 50-year low. Inflation also eased slightly as falling gasoline prices led the CPI to grow at a slower pace of 8.5% year-over-year versus 9.1% in June. The Democrats passed the Inflation Reduction Act through reconciliation, and the CHIPS Act was also enacted on a bipartisan basis.
But we think the outlook is still too uncertain for the Fed to pivot policy, as the recent encouraging trends in the data may not be sustained over the medium term. Indeed, Minneapolis Federal Reserve President Neel Kashkari on Tuesday said his biggest fear is that the Fed and markets are misreading the level of inflation, which could be more embedded at a higher level than appreciated.
Rapid job growth unlikely to last. With the unemployment rate already at a 50-year low and the labor force participation rate stuck around its current level, the rapid rise in payrolls cannot continue for much longer. Demographics suggest that labor supply should increase by around 100,000 per month, far less than the 465,000 average payroll gain over the last six months. Ideally, an influx of workers into the labor market will extend the period of rapid job growth, but it seems more likely that job growth will just slow as the US economy simply runs out of people looking for work. In any case, rapid job growth is no guarantee of economic growth as GDP was negative in both 1Q and 2Q.
Households may cut spending when savings run out. Another unsustainable trend is the declining personal savings rate. Consumer credit, including credit cards, has been rising rapidly as household struggle with high inflation. While the aggregate strength of household balance sheets could allow the savings rate to fall further, everything has a limit. One of the main downside risks for the economy is that households will cut back on spending when their savings are depleted. This would likely cause businesses to stop hiring new workers as demand drops.
Inflation is too high for a dovish shift by the Fed. On Friday, Fed Chair Jerome Powell will give a speech on the economy at the Jackson Hole symposium. With inflation way too high and the labor market very tight, we see little reason for Powell to adopt a more dovish stance. Instead, the message should continue to be that the Fed is determined to restore price stability, even at the cost of economic growth. Kashkaris remarks on Tuesday also underline this point. Markets are currently pricing in a Fed policy path that is more or less in line with the dot plot from the June FOMC meeting, which indicated rates would peak near 4%.
So, we think there remain too many uncertainties to consider a dovish Fed pivot anytime soon. Investors who are concerned about volatility and want to seek some downside protection may consider capital protection and dynamic asset allocation, which are good ways to position more defensively. Read more here. High grade bonds, resilient credits, and the Swiss franc can also help improve portfolio resilience. We also see opportunities to generate yield by selling volatility, i.e., forgoing potential upside or assuming exposure to market downside. Finally, we recommend investors tilt more of their portfolio toward value and defensive sectors, like energy and healthcare, to better withstand slowing economic growth.
Read the full report Too many uncertainties to expect a Fed pivot 25 August 2022.
Main contributors: Mark Haefele, Brian Rose, Patricia Lui, Vincent Heaney, and Jon Gordon
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