With some key PMIs already falling below 50, the window of opportunity for a constructive Fed pivot is narrowing. Any emphasis from Powell about having reached neutral (assuming a 75bp hike), having optionality on the pace of future hikes, and being data dependent (and downplaying forward guidance) would likely be well received by the market.

Monetary policy acts with a lag and inflation itself is a lagging indicator, even more so for trimmed-mean measures of inflation. (Trimmed-mean is a measure of inflation that discards the highest and lowest subcategory readings.) In my view, focus on trimmed-mean inflation was one reason the Fed was behind the curve last year. As far as I can tell, trimmed-mean tends to lag headline inflation—on the way up and on the way down. In other words, headline inflation will likely start going down before trimmed mean. The same dynamic is true of wage growth measures (e.g., the Employment Cost Index), which also tend to lag headline inflation. Any emphasis from Powell on trimmed-mean or wage inflation will likely be met with weakness in the market, as it increases the chances that the Fed oversteers. The reaction in 2yr and 10yr yields will be telling. 2yr yield up, 10yr yield down is a recessionary warning sign. 2yr yield down, 10yr yield up would be positive for the market and economic outlook.

This is an unusual business cycle, following an unusual recession. The unprecedented fiscal policy response created excess savings of around $2.5 trillion. Inflation-adjusted retail sales have been flattish since fiscal stimulus peaked in March 2021. But there’s still a large buffer of accumulated household savings. Fiscal tightening over the past five quarters and improvements on the supply side (e.g., delivery times are falling, inventories are growing) should help bring inflation down. As a result, inflation-adjusted retail spending may start trending higher again, which would increase the chances of a muddle-through outcome or make a coming recession mild.

Setting aside recession risk for a moment, in cases of inflation spikes coinciding with market declines, historically the market has bottomed (or been not far from the bottom) around the peak YoY rate of inflation. And headline CPI inflation very well maybe (finally) peaking.

There's never a perfect analog to the present constellation of factors. But it’s worth considering the post-WW2 inflation spike and 1946-49 bear market, ending in a mild recession. The highest inflation of the last hundred years was hit in March 1947 at 19.7% CPI YoY, in large part caused by the removal of wartime price controls, postwar pent-up demand, and supply shortages. After an inflation-related decline in 1946 into 1947, the market started to recover once inflation started to come down. The next recession didn't start until late 1948. It lasted 11 months and was directly associated with a 20.6% decline in the market. The recession low in the market (in 1949) was barely below the calendar year lows in 1946, 47, and 48. When inflation peaked in March 1947, the market was down 23.2% from the previous all-time high; the max drawdown, hit in 1949, was 29.6%, just 6.4% lower.

The rally in the market off the June lows is so far still consistent with a bear market rally. The market very well may make new lows, particularly if the economy slips into recession later this year or early next year. For now, the path of least resistance is probably lower. But even with a recession, the depth of the drawdown is likely more than halfway done, which leaves more upside than downside over a multi-year horizon. In short, there’s two-way uncertainty, but from current levels I see near-term risk as skewed to the downside and medium-term risk as skewed to the upside. I continue to view the current drawdown as a cyclical bear market (even with a recession) in an ongoing secular bull market.

This is a challenging market and economic environment to analyze, and uncertainty remains high. As always, everyone needs to put probability and reward-to-risk assessments in the context of their strategy, process, and time horizon.

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