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Macroeconomic Outlook: Now the Hard Part Begins

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By Joel Clark, CEO of KJ Harrison Investors

If you’ve ever watched a Marvel movie, then you know what a “superhero landing” is. A spandex-clad protagonist drops from a great height and acrobatically comes to rest on their feet in perfect athletic balance, one fist pounded into the ground and a puff of dust amplifying the sheer awesomeness of the moment; much butt-kicking generally ensues. It can make for exciting (if, by now, cliché) cinema, but it’s not exactly realistic. Only a superhero, with the aid of a good deal of Hollywood magic, can pull it off.

Sadly, perhaps, central bankers are not superheroes. They are real-life men and women, and while they are smart and educated and civic-minded, they are not generally capable of pulling off the impossible. But that’s what the U.S. Federal Reserve, the Bank of Canada and other monetary policymakers might be up against right now. Through aggressive rate hikes and quantitative tightening, they are fighting runaway inflation by curbing demand and slowing down the economy, and they are trying extra-hard because they know they are behind the curve. The good news is that it looks like these extraordinary efforts are working. Inflation is moderating; it might well have peaked. But now the hard part begins. Central banks face the daunting task of continuing to bring down inflation while not tightening so much that they tilt the economy into a deep recession. In short, they still have to stick the landing.

Through much of July and into August, equity markets behaved as if that was a done deal. Investors interpreted the surprisingly high June read for U.S. inflation (9.1%) as signalling the peak, and the lower July data (8.5%) seemed to confirm that interpretation. Commodity prices, which can provide a bellwether for inflation trends, moderated significantly during that period, led by oil. And the S&P 500 staged a rally – the fourth, by our count, during this bear market. In our view, this ebullient reaction might be premature.

For one thing, markets may be underestimating the probability of a severe recession, which obviously would not be good for stocks. The U.S. might already be in recession, of course, since its economy has experienced two consecutive quarters of negative growth – the textbook definition, though disputed by many economists (and by the current administration in Washington). But the technicalities do not really matter all that much, because a slowdown is obvious to anyone who pays attention to the data.

Leading indicators suggest that the slowdown will be significant. The most important is the U.S. Treasury yield curve, which inverted for the second time this year in June. Since then, the inversion has both broadened and deepened, and it now extends from durations of six months all the way out to 10 years. It is also approaching negative levels not seen since 2001-2002 or 2008-2009. That is a pretty clear red flag, given that the curve has inverted prior to every recession since the 1970s.

The important question in the second half of 2022 is not whether, but how much. How bad will the slowdown be? Will it be a shallow recession or a deep one? If it is going to be shallow, the burden of engineering it falls on the shoulders of central bankers. It won’t be easy. It is one thing to push inflation from its peak (if we can indeed check that box); it is quite another to get inflation down to target, which is in the range of 2%, or 6.5 percentage points lower than the July data. Not to put too fine a point on it, but there is still a long way to go. That’s why we suspect that Fed officials will be energetically talking back the markets’ dovish interpretation of recent inflation numbers and suggesting they will keep their foot on the tightening pedal in their September and October meetings. After all, central bankers cannot step back too quickly. They have to over-ensure that they put a knife in inflation.

But at what cost? The big debate right now is whether the Fed will raise

rates by 75 basis points or 50 coming out of its September meeting. The best-case scenario is that inflation continues to step down, the Fed has leeway to hike by “only” 50 bps and they somehow manage to soft-land the plane. But let’s be under no illusions about the powers of central bankers. They have a very poor track record for soft landings. What they have done so far has dramatically pulled liquidity out of the economy and the markets, but even that will take time to have full effect. It’s quite possible that they have gone too far already but we (or they) just don’t know it yet. And if they keep going to beat inflation back down to somewhere near target, they risk sending the economy into even more of a tailspin than it is already in.

A more realistic outlook might be that we are in for a few more rocky and uncertain months during which equity markets retest the lows they reached in June. If so, the hope would be that those lows represent a true bottoming out, establishing a base (for the S&P 500, around 3650) from which markets can build once the rate hikes of September and October are out of the way, and setting up a welcome end-of-year equity rally that could have legs into next year. In the meantime, conditions seem to favour income-generating securities, including government and investment-grade bonds, REITs, utilities and maybe even precious metals, which should outperform if we continue in slowdown mode.

For now, we should be careful what we celebrate. Central bankers might well have cracked the back of the inflation archenemy, but the fight is far from over, and we just don’t know how bad the collateral damage will be. Whether they can successfully tame inflation without tilting into a severe recession is still an open question. And superhero landings only happen in the movies.

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