Welcome to the Crossroads Economy
Investors are getting mixed signals from policy makers and the economy, it has become a struggle to work out which path to take.
Many investors often speak of their "investment journey" when it comes to managing their portfolios. If that is the right analogy, then monetary policy, fiscal policy, and economic developments should be the signals pointing investors down the right path. However, in the ever-evolving landscape of financial markets, investors have found themselves at a perplexing crossroads, where the signals from monetary policy, fiscal policy, and economic indicators seem to be providing mixed guidance.
Monetary Policy Signals: A Confusion of Central Bankers
According to Google, there is no collective noun for a group of central bankers; however, I would like to offer a potential answer: a confusion! This feels like an often-accurate way to describe monetary policy officials, and this has only been reinforced during the latest slew of central bank meetings that have occurred since the summer.
Investors have been left in a muddle following the September meetings, which have provided no clear policy direction and, if anything, have given rise to more questions than answers. The latest Fed dot-plots, where each policymaker provides an anonymous forecast as to where they think interest rates will go, suggested that US interest rates will stay above 5% throughout 2024. This 'higher for longer' interest rate stance was further reinforced by revisions to their economic forecasts, suggesting that unemployment will be lower and economic growth might be higher than they had previously expected. Picking through the details certainly suggested that the Fed was on a hawkish trajectory.
However, in the press conference, Fed Chair Jay Powell struck a much more cautious tone, noting that "We've covered a lot of ground, and the full effects of our tightening have yet to be felt," and that "Looking ahead, we're in a position to proceed carefully in determining the extent of additional policy firming that may be appropriate." Hang on a moment, that is a significantly more dovish message than what was conveyed in the economic forecasts and interest rate outlook. When queried on it by journalists, the Fed Chair downplayed the importance of the dot plot and economic forecasts, suggesting that they were not particularly relevant for the immediate interest rate outlook. This week, the Fed Chair was at it again commenting that he was unwilling to discuss changes in the neutral rate before subsequently providing guidance on where it might be going.
Feeling confused? You are not alone. Even the legendary investor, Mohamed El-Erian, Chief Economic Advisor at Allianz, noted that the policy signals and commentary coming from the Fed are "both confused and confusing." The Fed is not the only central bank adding to the monetary muddle. In their September meeting, the Bank of England opted to pass on hiking interest rates despite the fact that inflation remains well above their 2% target, and the hike had been almost fully priced in by markets.
Fiscal Policy Signals: Election Uncertainty
If you think deciphering monetary policy is a complex task, then take a look at the outlook for fiscal policy. Getting a reliable read on the direction of government spending in almost any corner of the globe is proving to be a dizzying job. The looming specter of elections in 2024 casts a long shadow over the subsequent direction of fiscal policy, as economists have little clue as to which party will be in office or what their potential economic objectives might be.
Media attention will almost certainly be focused on the elections in the USA, UK, and the European Union, which are all scheduled to be held by the end of next year. However, accurately predicting the outcome of elections is incredibly difficult given the global inflationary backdrop. While it is typically outside of the direct control of governments, the blame for rising prices is usually placed squarely on the shoulders of the incumbent politicians. Next year’s elections are therefore likely to see a significant amount of mud-slinging as leaders are forced to explain their imperfect economic records and will likely see a fair amount of turnover as disgruntled voters opt for change.
Against such a challenging economic backdrop and with the mounting possibility of losing power, politicians can be spurred into adopting drastic (often short-term) measures in order to stay in power. This may involve increasing government spending to try and win over wavering voters in key demographics. While this is no different from history, bond markets currently seem to be in the mood for punishing fiscally wayward governments via increased borrowing costs. If a desperate government decides that they would like to hold onto power through big fiscal giveaways, they are likely to see their bond yields shoot higher in response, worsening their long-term debt dynamics.
And while elections in the developed world are likely to dominate the headlines, investors should not overlook the fact that the political battles in emerging markets are heating up as well. Voters in important developing economies such as India, South Africa, Mexico, and Indonesia are all scheduled to go to the polls next year, increasing the risk of political and economic surprises. In total, emerging economies representing 25% of EM GDP are due to have elections by the end of 2024. This is already a high figure and doesn't include sudden, unscheduled elections that get called outside of the established electoral calendar, which will likely push that figure even higher.
Economic Growth: The Most Muddled Signal of All
With both monetary and fiscal policy offering up a bewildering array of conflicting signals, it is perhaps the economic data itself that is sending the most confusing sign. Despite elevated fiscal uncertainty and the most aggressive rate-hiking cycle since the 1970s, economic growth has remained remarkably robust. The much-predicted 2023 recession does not look set to materialize, and the strong US labor market continues to defy expectations. The September payrolls report, which provides figures on the US job market, smashed expectations, increasing by 336k, well above the average economist forecast of 170k.
The US labor market has indeed been an enigma this year, and financial markets seem to have become incredibly sensitive to each new data release, in the hopes that it will provide some much-needed guidance in these confusing times. However, there is a huge amount of noise in the labor market figures, and it can be easy to get lost in the numbers. For investors and policymakers, what matters most is whether the US job market is heating up or cooling off. The chart below does a good job of cutting through the noise and addressing that issue.
The quit rate is the number of people handing in their notices and leaving their current employment voluntarily. A high quit rate tends to be a positive sign in the labor market, as it suggests more employees are willing to leave their current positions in search of higher-paying jobs. The quit rate does a reasonable job of predicting where wage growth tends to go in about six months. The quits rate has spent much of the year declining, suggesting that wage pressure will begin to cool off.
Which Path to Take?
With economic data remaining robust, there has been a lingering feeling in financial markets that perhaps policymakers could actually pull off the much vaunted 'soft landing' by managing to tame inflation without triggering a recession. However, as we have discussed in previous blog posts, this positivity is likely to be badly misplaced. Fed rate-hiking cycles almost always end in a recession, particularly when considering how aggressive the current rate-hiking cycle has been. Furthermore, the below chart shows that the uses of the term ‘soft landing’ in company reports tends to peak just before everything goes wrong and a recession hits. While I would like us to end up on the easy-peasy pathway toward a 'soft landing,' in all likelihood, it feels like it would be wiser to brace ourselves and our portfolios for a recession.
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