Last week’s rate hike was the Fed’s fifth hike since January. The federal funds rate, now hovering around the 3 to 3.25 percent level, is likely to rise further before year-end.
Walking the fine line between fighting inflation and stimulating the economy in a post-pandemic environment has been a challenge for the Fed. And according to Jefferies Hong Kong’s Chris Wood, things will get a lot harder in the coming months.
“(To meet its inflation target) the Fed will soon have to face a real decision about how much it is willing to curb growth and suffer the collateral damage that comes with it, in an economy that is growing stronger after more than two decades of excess financialized was simple monetary policy,” Wood said during his keynote address at the Gold Forum Americas.
He attributed today’s rampant inflation to a pandemic money-printing policy that “paid people to do nothing,” thus stimulating “artificial demand.” Wood, his firm’s head of equity strategy, added that when the Fed stopped labeling inflation as temporary, it signaled the start of an era of “structurally higher inflation.”
Speaking of equity markets, he noted that for those who had bet on inflation continuing, “value has clearly become more attractive relative to growth”, although for a brief summer it looked like high prices were about to peak.
“But right now, I think all of that dynamic — whether it’s value or growth — while it’s still relevant, it’s not the key issue anymore,” Wood said. “The key issue is owning stocks that generate cash and pay dividends.”
Historical indicators show that a recession is imminent
Although the Fed appears to be in a uniquely precarious position, history can be a pertinent indicator of what lies ahead. In his “Fear and Greed in 2022” keynote, Wood highlighted the link between Fed policy and economic performance.
“Since the post-war period, the vast majority of federal tightening cycles have ended in recession,” he said. “So this has to be the base case this time, but there is a risk of a recession in the middle of next year rather than the next few weeks.”
In addition to the tough measures taken to rein in inflation, Wood warned participants that the Fed’s dovish strategy is not yet complete. “The other big negative for the stock market, aside from the fact that the Fed is raising rates, is that the Fed is also in the process of shrinking the balance sheet,” he said.
Wood added that the central bank’s policy reversal last November and signs that it would prioritize quantitative tightening were the two most important developments in US monetary policy over the past year.
“Quantitative tightening will happen much sooner than I or the markets expected,” he said. “It’s a double whammy – monetary tightening is about to start and markets aren’t really focused on the quantitative tightening aspects.”
Anticipating a deeper recession next year, Wood also expressed concern about an even stronger economic picture stemming from the explosion of US M2 – a measure of the money supply in US households – in 2020.
Using a chart, Wood explained that US M2 is up 40 percent in absolute terms since March 2020 but has spent much of 2022 in decline. In June, US M2 growth slowed to 5.9 percent yoy.
“This slump in monetary growth is really negative for the US economy next year,” he said. “But on the other hand, inflationary pressures are still dangling from the 2020 explosion.” In his view, this creates a “perfect environment” for stagflation.
Energy sector defensive in current circumstances
Wood offered some positive points, including insights into where investors could take refuge from market turbulence.
“If you think the Fed is really going to stay the course and keep tightening until headline inflation is below 2 percent, then I think you have a lot of money to make buying US Treasuries right now,” he said. However, he is skeptical that this will happen and instead believes the Federal Reserve is likely to bow to political pressure and fail to achieve that goal.
As the US M2 has reversed this year, US commercial banks are seeing credit growth that could facilitate a softer economic landing.
“If the US credit multiplier really kicks in, accelerating bank lending could theoretically mitigate some of the negative liquidity consequences of quantitative tightening,” Wood said.
In terms of stock sectors, the strategist told the gold forum crowd that his favorite is energy.
“I think people should understand that there’s a real risk that when you go into recessions and downturns, the energy sector is going to be a lot more defensive than it would normally be,” he said. In his view, the fact that concerns about demand squelching have led to a correction in energy supplies – despite an increase in consumption – is a catalyst for growth.
“The big difference in this cycle from previous cycles is the staggering lack of investment in the oil and gas sector, which is the direct result of the escalating political assault on fossil fuels in the G7 world in recent years, which has created an entirely negative stimulus has to invest in oil and gas,” Wood said. He added that fossil fuels accounted for 82 percent of all energy use in 2021.
Brent crude, now in the $86.09 a barrel range, rose to an 11-year high of $123.35 a barrel in March. For Wood, a key fuel threshold is $150 a barrel.
“The most important macro point to understand is if oil goes to $150…the Federal Reserve will be forced to tighten and there will be a real trainwreck in markets,” he warned .
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Securities Disclosures: I, Georgia Williams, do not hold a direct interest in any of the companies mentioned in this article.
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