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Mr. Dream

“Selling empty promises from every point of view…. Just call on Mr. Dream”

Billy Idol & Billy Morrison, May 2024

For those who have not seen it there was an excellent interview with Stan Druckenmiller overnight. The Druck was also perplexed by the December Fed pivot and the consequence of that for a reflexive and premature easing in financial conditions. As we noted last week, this has compounded a series of policy errors. When inflation was staring them in the face in 2021, their informed view was not to think about hiking rates. When inflation set on its largest and potentially structural surge of the last half century, they labelled it transitory and carried on with unholy QE while driving real rates into deep negative territory. When inflation was about to get sticky and re-accelerate, they claimed victory in their infamous December 2023 dovish pivot.

As the Druck noted, the Fed still seems to be hanging on the asymmetric directive that we are not going to hike, and we expect to cut but we are going to wait for the data. The RBA and other central banks are also trapped in a similar forward guidance dilemma. However, this is a strategy based on “hope.” The risk is that inflation does not confirm their beliefs. Tactically and fortunately for the doves, US April employment and JOLTS data last Friday combined to suggest a softening trend in labour market conditions and wages. As a result, Treasury yields have dropped again, vindicating Powell, easing financial conditions, contributing to a depreciation in the dollar and supporting a renewed rally in risk asset prices. Credit spreads also narrowed and implied equity volatility compressed.

Another interesting feature of the market price action this year is that equities are behaving as if a global cycle upswing is underway. The return on developed market equities relative to sovereign bonds is very pro-cyclical. Equity out performance this year is consistent with a strong cyclical upswing. Year to date sector performance also has a strong cyclical tilt. The best performing sectors outside the United States – energy, technology, consumer discretionary and industrials – are all cyclical. However, the risk for investors is that the un-even nature of the recovery in this cycle might make equities vulnerable to either a delay in policy easing or the prospect that a broad upswing is still some time away.

As Gerard Minack has noted recently, central banks are often willing to ease policy even with inflation above target if growth indicators are falling. Nothing douses inflation pressure like a recession. But will central banks ease policy if growth indicators are rising and inflation remains well above target? Probably not. Powell spent a lot of time at the May FOMC Press Conference reaffirming his bias that the owner equivalent rent component of high CPI should start to moderate soon, in line with a drop in market rents. However, core services ex shelter has been accelerating. From our perch, the Fed and other central banks ought to have a more symmetric rather than asymmetric bias on the path of future short rates, especially in the context of irresponsibly loose fiscal policy.

In that context, outright equity valuations for the S&P500 and select sectors remain elevated. The equity, credit premiums and implied volatility also remain too narrow. We remain defensive (below target equity allocation) in our portfolios.

20240508_Mr. Dream
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