Loosening Financial Conditions and Accelerating Inflation Set Stage for a Powell Strike Out

By:

Interactive Brokers’ Senior Economist

The manufacturing and services industries continue to buckle under the weight of higher interest rates and high prices, which is supporting investor optimism that the Federal Reserve is likely to ease up on its tightening of monetary policy. The recent favorable outlook for a moderating inflation battle comes as investors have been rotating aggressively into growth stocks in anticipation that interest rates may not rise as high or for as long as previously anticipated. This trend along with lower bond yields is contributing to more favorable financing conditions for investors, which is likely to require the Federal Reserve (the Fed) to stick by its guns in fighting inflation.

This morning’s S&P Global January Flash Composite Purchasing Managers Index rose from 45 in December to 46.6 this month, reflecting modest improvement in the pace of decline but remaining in contraction territory (below 50) for the fourth consecutive month. Services and manufacturing both contributed to the higher headline although it’s important to note that both categories are still contracting, a recessionary characteristic. Corporations reported weak demand as fragile consumer sentiment, higher interest rates and high prices weighed on purses and money-clips alike.

Perhaps most concerning and consistent with our in-house inflation models, input prices rose after moderating for seven consecutive months while selling prices also increased, driven by the persistently tight labor market and to a lesser extent rising food and oil prices.

Perhaps most concerning and consistent with our in-house inflation models, input prices rose after moderating for seven consecutive months while selling prices also increased, driven by the persistently tight labor market and to a lesser extent rising food and oil prices. For better or for worse, today’s data reported the coolest job growth in at least 13 months as companies were hesitant to add labor supply as we potentially enter recession. Manufacturers cut their workforce this month while servicers continued adding at a far slower-than-trend pace. While high tech layoffs have been the most visible, 3M this morning announced it is laying off 2,500 global manufacturing jobs while temp staffing is declining. I still believe, however, that low labor force participation will continue to support tight labor markets while the incoming recession will only feature modest increases in unemployment. The coming downturn is likely to pressure affordability, margins, earnings and investment but not be characterized by significant unemployment.

European PMI results fared better, improving from 49.3 in December to 50.2 in January. Eclipsing the 50 expansion-contraction threshold is a big development signaling a return to short-term economic expansion in the euro area. Slower inflation, improving supply chain efficiency and a milder winter served to boost business confidence, leading to an improvement in the composite PMI. The UK, on the other hand, worsened from 49 to 47.8 during the period while France and Germany, the EU’s two largest economies, remained below 50.

The continued slowdown in U.S. business conditions comes as many equity investors have rotated into growth equities in anticipation that interest rates won’t climb as high as previously expected.  The Russell 3000 Growth Index, year-to-date as of the close of the market on January 23, is up 6.51% compared to the 4.06 % return of the Russell 3000 Value Index. In comparison, the Russell 3000 Value Index, with a decline of 7.98%, dramatically outperformed the -28.97% return of the Russell 3000 Growth Index last year. Broadly speaking, growth stocks are more vulnerable to rising interest rates than value stocks. Growth equities are typically valued based on the value of future earnings relative to interest rates. As interest rates moderate, therefore, the future earnings stream of growth stocks is more appealing, resulting in higher valuations.

Investors rushing into speculative areas of the market may be served with a Jackson Hole style strikeout at next week’s Fed meeting. Last August, financial conditions loosened significantly after dipping from June highs as progress on inflation due to declining gasoline prices boosted investor sentiment regarding a potentially less hawkish Fed. With Powell at the helm, the loosening of financial conditions works specifically against the Fed’s goal of reigning in inflationary pressures. Similarly, the S&P 500 was near its year-to-date downtrend line and its 200-day-moving average when Powell dashed hopes of a less hawkish Fed at Jackson Hole last August. A similar phenomenon is occurring today, with financial conditions loosening for 13 consecutive weeks, going against the Fed’s goals. Heading into the Fed meeting next week with the bulls up to bat ahead in the count 3 balls and 2 strikes, the chances of a Powell style slider appearing like an outside ball may prove a nasty surprise right above the plate. Strike three you’re out, on to the next inning ladies and gentlemen.

Financial conditions are loosening significantly, similar to Jackson Hole, setting up the stage for a Powell strike out

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