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If the First Wave Doesn't Get You the Second Wave Will

Earlier this week we suggested that the odds of a soft landing remain low. There have been only 2 out of 12 episodes since 1957. The most recent was 1995 and the Conference Board Index of 10 leading indicators is materially weaker than in that episode. Moreover, real rates are now around 2% which is restrictive relative to most estimates of neutral or equilibrium. Recall, the United States is a “long rate” economy with most borrowing sensitive to the long end of the yield curve. The 10-year real yield is near the level last seen in 2008 (chart 1).

The good news for equities is that there has been a sustained phase of disinflation over the past 12 months. That has contributed to a peak in nominal short term interest rate expectations. However, if the current disinflationary impulse (on core) does not result in a moderation in final demand and higher unemployment, then it is possible that lower inflation will boost real disposable incomes and contribute to a second wave of inflation. That would prevent the Fed from cutting rates (as is currently priced into the futures markets) and might lead to a further increase in the policy rate above 6% (chart 2).

While the Fed is acutely aware of the policy error (the risk of a second inflation wave) the mistake could be repeated in the current episode if the Fed pauses too soon. A second wave of inflation would likely be challenging for equities, especially given current valuation multiples and the absence of an equity risk premium (chart 3).

The current data – high real rates, leading indictors of the labour market and final demand suggest that left tail growth risks are greater than right tail ones. The Redbook retail sales data leads core inflation by around 5 months and is consistent with a material deceleration in demand and future core inflation pressure (chart 4). Unemployment should start to rise (from trough levels). However, if the labour market and real disposable incomes remain firm it is plausible that inflation pressure might build again over the coming months. There has been a material rise in energy prices, for example, over the past few months.

Another policy error in the mid-1960s was aggressive fiscal easing to finance the Vietnam War when the economy was operating at full employment. The current fiscal impulse (change in the budget balance) over the past two quarters has never been more stimulatory, aside from the pandemic and 2008. That is probably a policy error given the economy is operating close to full employment and risks more restrictive policy by the Federal Reserve. While we see greater left tail risks to growth, the current fiscal impulse could be a right tail risk. Of course, the consequence would also be higher interest rates. We are not convinced high multiple equities have an adequate margin of safety for that risk.


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