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Inflation in October came in lower than expected in the US (7.7% vs 7.9% expected). One key factor is that owner equivalent rent (OER – see Graph) decelerated from 4.2% to 3.9% which is very important as Shelter (rents) represents 32.7% of the CPI weight. OER is assessed by asking home owners how much they could rent out their place. It indicates that leveraged households are starting to become worried that the real estate market is turning on them as inventories build up, valuations are very expensive and many moved during the Covid-19 crisis to expensive real estate, in decisions that were taken too quickly.
With better than expected inflation, the market is now speculating on fewer rate hikes ahead of a pause and an eventual Fed pivot. A pivot is defined simply as a change of direction in terms of monetary policy – in this case towards easing, when the Fed has actually flagged an extended pause to assess the impact of past monetary tightening. A pivot makes sense to the market because the Fed historically overtightens monetary policy so that households and corporates see clearly a slowing inflation & growth mix when much of the impact of monetary policy will be felt four to eight quarters down the road. Once, the Fed wins the game on inflation, it eventually eases with falling inflation. The difference this time around is that the market expects a far more rapid fall in inflation than history suggests (we agree) and a pivot in 2024 which is likely (see Graph below of Fed Funds Rates). Most expectations are for a shallow recession in the United States (i.e. no severe crash in the housing market) reinforced by a restrictive fiscal policy as it seems the Republicans will have a slim majority in the House. That makes it likely that in 2024, we see a cycle of monetary easing.
US midterm elections – No red wave
The Midterm elections were not the Red wave Republicans were hoping for following the shock to households of very elevated inflation. This shock was largely a function of the Democrats deciding to run the economy hot to favor less skilled workers, a Fed which had changed its inflation & growth mandate to favor this and dysfunctions in the supply chain.
Many Trump backed candidates failed to perform, putting Donald Trump on the defensive on what was expected to be the announcement of his presidential candidacy. Results are still uncertain with Republicans likely winning a small majority in the House, while the Senate stays Democratic. There are a few points afferent to this:
1. A fiscal contraction is likely with the House controlled by Republicans. Decisions on any fiscal deal will require the cooperation of individuals who will seek advantages for their constituency. This could drag the US into a technical default if Democrats take a risky strategy of trying to force Republicans into looking fiscally irresponsible.
2. Ron DeSantis with a solid win in Florida is now a major national figure potentially eclipsing Donald Trump in the Republican party. DeSantis can be described as preferring spending cuts, a Ukraine Hawk, somewhat pro-climate change, an immigration hawk and someone who would audit the Federal Reserve. That makes him a far more mainstream candidate than Trump but still within a movement, he would most probably eventually leave for his own.
3. Pressure on Joe Biden is likely to build in the Democratic party to leave the way to a more viable candidate able to confront what may well be DeSantis. Possible candidates according to The Hill are Transportation secretary Pete Buttigieg, Michigan Governor Gretchen Whitmer with Dems controlling all three branches of government and California Governor Gavin Newsom with a solid win.
What does it mean?
As the odds of a Fed pivot increase, we should see some bouts of outperformance of equities. The reality though is that it also reflects lower profit margins as demand slows which means still some equity volatility ahead. In such a scenario, we prefer to be long equities that offer robust cash flows in a slowdown and not too expensive valuations. The spiral of risk taking into fixed income products could take a few short months. It should start first with sovereign long-dated fixed income as odds of a Fed pivot increase, then credit as the bottom of the economic slowdown is priced in with its consequent default rate. Over weeks, the ability to forecast the mix of growth & inflation and resulting ability to forecast the Fed’s policy & corporate default rates should improve helping a broad swath of financial assets.