In brief

• From Jackson Hole: the Federal Reserve’s (Fed’s) primary task to control inflation is not done. More rate hikes to come even if this means weaker growth
• We expect 75bps hike in September Federal Open Market Committee (FOMC) meeting, but it’s a close call. The August job and inflation data could still swing the Fed’s decision and market expectations
• After a summer of risk-on rally, growth concerns could return and we maintain a more cautious stance on asset allocation. The emphasis on quality for equities and fixed income should help build portfolio resilience

The Federal Reserve is still focused on beating inflation

A key takeaway from the annual symposium of central bankers at Jackson Hole is that inflation in the U.S. is still a problem and more needs to be done to tame price increases, even if this leads to a period of weaker growth. The recent drop in bond yields, and subsequent easing in financial conditions could also have prompted the Fed to reiterate its hawkishness. Fed chair Jerome Powell said that the Fed “must keep at it until the job is done” and to push inflation down could result in a lower economic growth for “a sustained period”.

While Chair Powell’s latest comments are consistent with other senior Fed officials in recent weeks, this was clearly disappointing for the markets. Prior to the meeting, investors were indicating, via the futures and Overnight Index Swap market, that they expect policy rates to peak in the next six months and start to come down in 2023. Powell’s speech pushed back against the market view. In particular, it is willing to keep rates high and tolerate weaker growth to achieve its inflation goal, i.e. don’t expect rate cuts in 2023.

The futures market is now pricing in a 66% chance of a 75bps hike in the September 20-21 meeting. Now the market is expecting policy rates to peak at 3.75-4.00% in early 2023. We think we could get there before 2022 year-end with 75bps hike in September, 50bps in November and 25bps in December.

Since we still have the August job numbers this week and another round of Consumer Price Index data before the September Fed meeting, the outcome can still change. Weak job and/or inflation data could still persuade the Fed to opt for 50bps on September 21. Yet, hawks would argue that a 75bps hike would reinforce the Fed’s determination to control inflation, after failing to address it early in the cycle. The current inflation and growth trajectories imply 2023 could see small quantum of hikes, while providing limited rationale for cuts.

The Fed is indeed in a dilemma. The recent drop in gasoline prices and selected service costs are helping to bring headline inflation down. However, there is still considerable momentum from the demand side to keep core inflation elevated for some time. A study by the New York Fed has shown that at the end of 2021, about 60% of inflation in the U.S. can be explained by aggregate demand, which has been boosted by aggressive fiscal stimulus, and now the robust job market. This is where the Fed will need to tighten policy to cool things down. 

Exhibit 1: CNY weakness began after U.S. Treasury yields started rising above Chinese government bond yields

Source: FactSet, WM/Reuters, J.P. Morgan Asset Management. 
Data reflect most recently available as of 25/04/22.

On the other hand, there are signs that the U.S. economy is already cooling. Out of the six key economic indicators that we track to gauge recession risk, consumer confidence and ISM manufacturing new order sub-index have already fallen to levels consistent with recessions. Yet the Fed will probably give more weight to job growth, which is still in a very strong shape for now. 

Exhibit 2: U.S. economic indicators
Percentile rank relative to historic data since 1990

Source: Conference Board U.S., FactSet, Institute for Supply Management, U.S. Department of Labor, J.P. Morgan Asset Management. Elevated recession risk flags are shown when the underlying indicator is at a level consistent with the onset of any of the three recessions prior to the COVID-19 recession. Transformations used for each of the indicators are % year-over-year change for the Leading Economic Index and Consumer Confidence Index, index level for Leading Credit Index, ISM non-manufacturing and ISM manufacturing new orders and three-month moving average of monthly absolute change for non-farm payrolls. Past performance is not a reliable indicator of current and future results. 
Guide to the Markets – Asia. Data reflect most recently available as of 24/08/22.

Investment implications

We have been warning for some time that the risk to the summer equity rally would be for the Fed to be more hawkish than the market expect. Not only this would introduce additional downside risk to the U.S. economy, the valuation re-rating in equities, especially in the growth sectors, could reverse. This makes the Summary of Economic Projections from the September FOMC meeting critical, since this will show whether Fed officials are keeping to their June forecasts on policy rates or revising them higher again. The unemployment rate forecast also deserves some attention, since this reflects the amount of economic pain the Fed is willing to tolerate.

Hence, our view of staying more focused on portfolio resilience, with a preference for fixed income, remains unchanged. For equities, valuation de-rating in the first half of the year was responsible for equities’ challenging performance. More downgrades in earnings could be the theme for coming months. The focus on quality companies who can deliver more consistent earnings performance over weaker growth would be preferred.

We would also expect Asian domestic demand to show resilience in a weaker global growth environment. Many ASEAN economies are going through economic reopening now and more northeast Asian economies could follow suit later in the year. This should benefit companies serving domestic demand and the service sector (link). However, it is worth noting the U.S. dollar (USD) has strengthened in recent weeks both on the back of USD yields rising and more cautious risk appetite. This could be a near term challenge to emerging markets and Asian assets.

On fixed income, high yield (HY) corporate debt in the U.S. has outperformed in 3Q on the back of the risk rally. HY credit spread has tightened back to its 10-year average of around 500bps. While there would be risks for spreads to widen on weak economic data, the current yield level and constructive fundamentals could still appeal to long-term investors who are less sensitive towards price fluctuations. High grade corporate credits should be providing a more consistent performance as we ride out the Fed’s hawkish stance. 

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