A Reactive Fed Must Act
Teresa Kong, CFA, explains how the U.S. Federal Reserve must now play catch-up to contain inflation and provide stability to the global economy.
What’s your outlook for U.S. inflation?
We think the U.S. is near a year-on-year inflation peak, however, history tells us that inflation tends to subside slowly. By most measures, goods inflation has room to come down. Services inflation, however, will likely rise. So while the April U.S. Consumer Price Index (CPI) number came in at 8.3%, a tad below the March print of 8.5%, I see it staying elevated in the high single digits and not falling materially enough to stem the current market volatility in the coming months.
How do you think the Fed will respond?
We think the Federal Reserve has become reactive instead of pre-emptive. As soon as it realized that inflation wasn’t transitory in November of 2021 it should have been pre-emptive and hiked rates more aggressively. The Fed didn’t because it probably didn’t want to spook the markets into having another taper-tantrum. But the Fed’s mandate is clearly to promote maximum employment and stable prices. Nowhere does the Fed charter say anything about supporting asset prices.
There is currently little tradeoff to the Fed’s dual goals of maximizing employment and price stability. The U.S. labor market is at full employment based on most measures and wage growth is north of 5%. So the Fed clearly needs to and can afford to prioritize fighting inflation now as the labor market is healthy across all segments. I think the Fed may need to hike more than what is currently priced in the markets, which is two steps, or 50 basis points (0.50%), in each of the next three meetings, in June, July and September, in order to play catch-up.
What are the implications for the markets?
I think the salient question driving the markets in the coming months is whether the global economy is going into stagflation. Has the U.S. already experienced the first quarter of a two-quarter negative growth trend, which is the official definition of a recession? Remember U.S. economic growth was a surprise negative for the first quarter. While I think that U.S. gross domestic product (GDP) will in fact be positive for the second quarter I am more concerned about growth prospects in the Eurozone. I expect volatility to remain the only constant until there are clear signs of falling U.S. inflation and a resolution to the war in Ukraine.
What’s your outlook for Asia and China credit?
Within this uncertain context, the U.S. dollar Asia high-yield bond market will be driven by continued defaults in my view. On the sovereign side, we’re already seeing frontier markets struggling from two years of fighting Covid. Sri Lanka, for example, has declared a debt moratoria on its public borrowing. Even though the prime minister resigned, amid escalating violence over food shortages and surging prices, his brother remains president and it’s not clear how quickly logistics and supply challenges can be remedied to put daily necessities back on the shelves.
Among Asia corporates, most of which are China-based, the weak property sector will continue to see restructurings of smaller developers who have hit a liquidity wall and cannot refinance their offshore maturities. Thus I remain cautious on Asia credit. Short duration investment-grade credits will likely be the first to recover as short-end Treasuries have sufficiently priced in hike expectations.
What are the economic implications of China’s zero-COVID policy?
If China follows an increasingly pragmatic implementation of its zero-COVID policy it could mean a faster recovery in China and lower probability of global stagflation. Macro easing measures like lowering of mortgage down-payments have been stymied by the systematic lockdown of major tier 1 cities. The silver lining is that China seems to be implementing weekly testing in the large cities to strategically quarantine exposed groups instead of continuing mass lockdown of entire cities.
However, the world should not count on China as the tide lifting all boats. Even though a recent high-level Politburo meeting re-emphasized the need to reach the annual growth target this year of 5.5%, we expect China to complement its traditional capital expenditure-intensive infrastructure spend with substantially more “soft” infrastructure investment on public services like health care and education. This type of spend will likely have a more positive impact on domestic consumption than on global growth.