“I love it when a plan comes together”
If Bloomberg reports are correct, it appears as though Jay Powell is likely to be re-appointed as Chairman of the Federal Reserve with Lael Brainard as Vice Chair. That combination suggests that the Fed is likely to remain dovish with an emphasis on being reactive to labor market data rather than preemptive on inflation risk.
As we noted this week, our sense is that the Jackson Hole meeting is likely to be a non-event with respect to an announcement on the pathway for policy normalization. Rather, the message from Jay Powell is likely to emphasize that “reduced accommodation” will probably remain dependent on further “substantial progress” in the labour market and reduction in the employment shortfall from pre-pandemic levels.
The precise interpretation of that benchmark is still not clear. However, our sense is that if there is another solid gain in payrolls over the next two months the Fed is likely to announce a taper at the September FOMC and start a reduction in asset purchases in November. Other Fed Governors have suggested that the taper would likely proceed over the following 8 months, setting up the first rate hike for mid-2022. Based on leading indicators of employment such as the jobless claims and job openings survey the target should be met for a November taper (chart 1). Jobless claims are almost back to pre-pandemic levels and job openings are well above the 2019 peak. Of course, as we noted yesterday, a material tightening in financial conditions from a sharp drop (-20%) in equity prices, could alter the timeframe.
In terms of market signals, we will be focussed on the US dollar, to judge how price is assessing the odds of the timeframe on Mr. T (taper). The dollar index is poised at a critical juncture (chart 2). A further phase of dollar strength might signal a tightening in dollar liquidity and could be disruptive to markets, particularly in EM. On the positive side, as we noted above, the Fed under the leadership of the A-Team is likely to remain reactive and cautious. Moreover, the stage of the cycle matters, macro conditions have transitioned to mid-cycle, but expansions usually don’t end until policy is tightened. That process is only getting started.
The final point to note is that the equity risk premium (or the difference between the earnings yield on equities and the real yield on Treasuries) is still abnormally high, particularly in Asia. Put another way, the risk compensation still favours equities given the stage of the cycle and the likely ongoing expansion in growth and earnings as the economy re-opens over the coming months. While the recent correction related to the peak in liquidity and growth momentum (rate of change) was partly warranted, our sense is that fear of the delta variant on macro conditions has become an emotional overreaction.
Of course, it has been priced a lot more into cyclicals, reflation assets and EM/Asia than it has been in the S&P500. In a regional context, the slowdown in the rate of change in Chinese credit has also been a legitimate negative influence. In conclusion, any further correction in Asian equities related to the mini growth scare or withdrawal of liquidity (Mr. T) is an opportunity to scale up exposure in the region.