Rudi’s View: Don’t Fight The Fed

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In this week's Weekly Insights:

-Don't Fight The Fed
-Beware The Bear!
-The Quote
-Conviction Calls
-Rudi Talks
-Recent Weekly Insights To (Re)Read

By Rudi Filapek-Vandyck, Editor FNArena

Don't Fight The Fed

One of the defining events for global finance in 2022 happened during the Wall Street Journal Future of Everything Festival at which Fed Chair Jerome Powell spoke on May 17 and -finally!- got the message out the world's most powerful central bank is now singularly focused on bringing inflation down towards 2% (from 8%-plus).

His admission this would not be possible without causing some pain, including the unemployment rate rising, would have rattled a few, but that was the explicit intention.

For many years investors have relied on the Federal Reserve to bail them out when markets showed their vulnerability and proved at risk of breaking down. With the 2020 experience still fresh in mind, many an investor the world around has become used to the fact that buying-the-dip is a simple but highly effective strategy.

Now the Fed is no longer aiming to prop up the economy through rising financial assets, and thus attitudes towards risk-taking and spending need to change. Across the USA, but preferably including the rest of the world too.

While inflation is stuck in between ongoing covid restrictions and supply-side disruptions and challenges, with the Russia-Ukraine war adding its own twist, the only way to tame inflation is thus by reducing demand. And in order to reduce demand, consumers need to become less comfortable with their financial situation and prospects.

Central banks have no control over global supply chains, but they wield enormous leverage over credit and financial assets. Bringing down asset values, and thus make consumers feel a lot less comfortable, seems but the most logical policy aim to pursue in 2022.

The exposure of US households to US equities has never been greater. Plus add a whole new generation of young "investors" who don't genuinely know the practical implication of 'risk' and believe, with conviction, that owning crypto-currencies and NFTs is the quickest route to becoming a billionaire before celebrating their 30th birthday.

In Australia, a similar observation can be made about a general perception that housing prices never fall, mate.

The Federal Reserve needs to change all of that in order to successfully rein in what it had mistakenly considered as a temporary, "transitory" phenomenon throughout 2021. For the record: it is still possible inflation post-2020 might prove transitory on many accounts, but central bankers can no longer afford the luxury of sticking with a wait-and-see approach.

The risk of inflation becoming embedded is simply too high and would be many times over more damaging than the pain inflicted through an aggressive path of tightening. The Fed is all too aware of this. Note, for example, how Powell himself has recently started to include references to Paul Volcker, the central banker widely credited with slaying the inflation dragon in the early 1980s.

The Volcker Fed's aggressive tightening caused two economic recessions at the time, but it did pull down high inflation to manageable levels.

The message Powell has been trying to get across is that today's Federal Reserve is just as determined to put inflation back in its bottle. However, after more than a decade of explicit central bank support for financial assets in order to stave off structural deflation, most investors still have failed to comprehend the deeper meaning of the change in central bank messaging.

We know what to do, and we know how to do it, Powell declared at the WSJ Festival, adding there should be no doubt, the Fed will do what is necessary. "What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that"- those were his exact words.

Judging from price action since, it appears markets have finally understood the old saying of 'Don't Fight The Fed' now has a different meaning. The Fed wants less risk-taking, less confidence and less spending. Jobs will be lost. Asset prices will come down. But it's the pain that needs to happen, because inflation is a much, much bigger threat to everybody's wealth and future prospects.

Of course, it goes without saying, the Fed does have an ideal scenario in mind: "What we need is to see really growth moving down from the very high levels that we saw last year, moving down to a level that’s still positive, but that will give the supply side a chance to catch up, and a chance for inflation to come down as we get supply and demand back together."

This sounds great, except for the fact that Powell also acknowledged the Fed does not control everything that impacts on the economy. "There are many global events going on… that are really not under our control as well."

But, and this was clearly the message Powell was pushing across, it won't deter this Federal Reserve from executing on what, simply put, needs to be done:

"We know how people are suffering from high inflation. And we have both the tools and the resolve to get inflation back down. And no one should doubt our resolve in doing that."

Conclusion: Don't Fight The Fed in 2022 means:

-bond yields need to be higher, demand for credit needs to be tempered
-asset prices, including equities & real estate, need to be lower
-demand for products and services needs to be lower, which implies economic growth needs to be tempered

Fighting inflation is now the main goal – everything else is of secondary importance, at best.

"What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down. And if we don’t see that, then we’ll have to consider moving more aggressively."

Let's all hope inflation is, indeed, transitory, and highly susceptible to slowing growth and rising interest rates. The alternative might prove devastating in a way only few among us are willing to contemplate.

P.S. Bond yields may not have much further to rise from here, but the focus already is shifting to economic growth and corporate margins and profitability. Key question: how low?

Beware The Bear!

Stocks go up, stocks go down. And whoever observes share markets on a daily basis fully well knows there are all kinds of variations in between.

One thing remains, however, and that is that writings about the share market read differently when placed in a different context.

The story below (see link) was written two months ago. It's not an attempt to predict what happens tomorrow or next week.

It's pointing to a broader picture framework that I believe remains as important as it was earlier in the year, irrespective of what happens in the short term.

Rudi's View: Double Your Protection, (re)read the story here: https://www.fnarena.com/index.php/2022/03/17/rudis-view-double-your-protection/

The Quote

Economists at CIBC perfectly summarised this year's set-up for financial markets:

"The biggest threat to the overall stock market at this point is that growth and inflation won’t show a sufficient response to the early rounds of interest rate hikes.

That would not only see the Fed ramp up its monetary tightening, but as history shows, add to the risks that the central bank will push the economy into recession as it seeks that easing in price pressures."

Conviction Calls

From the latest update by the Wealth Management team at Morgan Stanley:

"We continue to recommend a neutral allocation to equities with a preference for defensive exposures (i.e. Healthcare, Infrastructure, Minimum Volatility) combined with inflation hedges (i.e. Materials, Energy) alongside exposure to higher yields (i.e. Value).

"Within equities, Australia remains preferred in the current environment given the recent de-rating, defensive quality attributes and higher relative yield."

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Wilsons latest thoughts on Australian and global equities:

"Australia is a lot further away from a bear market correction and should continue to demonstrate some relative resilience, but a US recession or a soft landing will likely determine how Australia performs over the coming year, even if the local economy itself avoids recession.

We remain tactically cautious but have not moved to an outright bearish stance on risk assets. Our base case is for improved performance over the coming year as inflation cools and the US and local economies slow but continue to expand."

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Economists at Citi:

"Hard landings are the historical norm when the Fed seeks to damp strong demand and bring down inflation.

"The tailwinds from nominal income growth and demand momentum we think make a 2022 recession unlikely, but the probability rises rapidly in 2023 and beyond as Fed officials seek to cool down an overheating economy by tightening financial conditions through lower equity prices and higher real interest rates."

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The team of software afficionados at Shaw and Partners is reporting general interest in the beaten-down sector in Australia is picking up, as judged from clientele at the broker calling up and asking questions once again.

The team's Top Picks for the sector in Australia are Whispir ((WSP)), Gentrack Group ((GTK)), Keypath Education International ((KED)), Elmo Software ((ELO)) and ReadyTech Holdings ((RDY)).

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Damien Boey, chief equity strategist at Barrenjoey:

"US housing demand continues to weaken on the back of higher rates and deteriorating affordability. Demand weakness is starting to weigh on supply as well. We are wary of earnings risks to US homebuilders but we also worry about broader negative implications for global cyclicals and banks."

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Guardians of Model Portfolios at stockbroker Morgans have decided the Core Model Portfolio sells out of APA Group ((APA)) due to overvaluation and add some more exposure to Transurban ((TCL)) instead.

The Growth Model Portfolio made no changes by late April, though the broker reports several candidates popped up for discussion, including Tabcorp Holdings ((TAH)), Aristocrat Leisure ((ALL)), Corporate Travel Management ((CTD)), Reliance Worldwide ((RWC)), and Megaport ((MP1)).

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Shaw and Partners has tried to identify the next possible M&A targets, with the selection limited to stocks under the broker's coverage.

Shaw's top 5 candidates to attract a suitor are Aussie Broadband ((ABB)), Atomos ((AMS)), Capitol Health ((CAJ)), Family Zone ((FZO)), and Monash IVF ((MVF)).

But wait, others are also likely to become a corporate target: Apiam Animal Health ((APM)), Damstra Holdings ((DTC)), Global Data Centre Group ((GDC)), Healthia ((HLA)), Money3 Corp ((MNY)), Probiotec ((PBP)), Plenti Group ((PLT)), Smartpay Holdings ((SMP)), and Zip Co ((Z1P)).

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Market strategists at Macquarie:

"We think high market valuation levels limit upside risk for equities, especially given central bank hikes will pressure growth and valuations."

"The strategy portfolio remains overweight Resources and defensives."

Rudi Talks

This week I am presenting to members of the Australian Shareholders Association (ASA) in Busselton, WA.

The event will be recorded and made available in the days following. Next week's Weekly Insights should have a link included.

Recent Weekly Insights To (Re)Read:

-Trend Is Turning For Corporate Profits: https://www.fnarena.com/index.php/2022/05/12/trend-is-turning-for-corporate-profits/

-A Bear Market Anomaly That Confuses: https://www.fnarena.com/index.php/2022/05/05/rudis-view-a-bear-market-anomaly-that-confuses/

-Peter's Portfolio Reviewed: https://www.fnarena.com/index.php/2022/04/13/rudis-view-peters-portfolio-reviewed/

-2022, The Big Adjustment: https://www.fnarena.com/index.php/2022/02/17/rudis-view-2022-the-big-adjustment/

(This story was written on Monday 23rd May, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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