| Uri Greenfeld, the chief strategist of Psagot Investment House
Is England the canary in the coal mine? Like quite a few people, we at the summits have also asked ourselves over the past two years how the experiment of printing the trillions in the world will end? Inflation was the immediate answer, but more than once we also mentioned the risk of a disconnection between the central bank and the government due to the gap between the former’s need to stop inflation and the latter’s desire to make potential voters feel comfortable.
As an example of past events where such a disconnection was a threat to the markets, we brought Israel in 2001 and the USA in the 1950s against the background of the Korean War (the Fed financed the American government quite a bit of the World War II effort. When the government saw that it was good and asked for support to get out The Fed refused to go to war in Korea and American bond yields soared). The recent events in Great Britain show that this type of risk has not gone away from the world and may become significant, especially in Europe.
Already today in the UK and the Eurozone, monetary policy has had to make adjustments that make it much less effective. In Great Britain, the central bank was forced to return to buying bonds to prevent the collapse of the pension bodies. In the Eurozone, too, the cracks in the ECB’s policy are beginning to show, when the central bank’s desire to fight high inflation comes up against the fact that government bonds are approaching the 5% mark, a mark previously held as a point of no return.
Therefore, if, for example, Georgia Maloney wants to keep her promises of tax reductions in Italy, it is likely that the ECB, which is forced, against its will, to continue financing the Italian deficit – will not be very enthusiastic. The ECB’s opposition to the move could, on the one hand, generate additional political noises in the Eurozone, which is also not very calm, especially before the coming winter, and on the other hand, lead to a loss of confidence in the central bank’s ability to prevent Italy’s debt crisis, which was simply postponed by 10 years and the problems It has never been treated.
At this point it is worth noting that also in this aspect it seems that Israel is in a much better place compared to the rest of the world. Not only is the inflation here less high and allows the Bank of Israel to be relatively “gentle” in terms of its policy, but also that the fear that the increases will lead to a crisis and that the government (the one that is formed, when it is formed, if it is formed) will have to oppose the Bank of Israel’s policy, is almost non-existent.
| The Fed inflates an experimental balloon
Last Friday, the Fed inflated an experimental balloon for the markets with the help of an article in the “Wall Street Journal”, and there is no doubt that the results of the experiment can be defined as a success. At the end of the day, and following the article, the stock markets rose sharply and the bond yields that climbed throughout the week – fell.
So what was it about the article that investors liked so much? According to the “Wall Street Journal” (which is generally seen as the Fed’s mouthpiece), after the next increase, which will again be 75 bps, the Fed will examine the possibility of changing the policy further down the road. The change of direction may be reflected in a slowdown in interest rate increases, a halt or even interest rate reductions.
This statement by the Fed gave investors the first sign that it might be possible to finally hold our breath and wait for the next chapter of Fed policy – what in market jargon they like to call a Pivot.
It is quite clear that the Fed will not immediately switch from the current policy to a policy of interest rate cuts. It is not necessary for the interest rate to fall for the sentiment in the markets to improve significantly. At the current point in time, the variance of interest rate forecasts may reach a full percent within a three-month period. Such uncertainty about the rate of interest rate increases is so high that it is almost impossible to build an investment strategy based on pricing or a macroeconomic scenario.
Therefore, even if the Fed continues to raise interest rates but at a slower and more stable pace, and even if interest rates remain high for most of 2023 (which currently seems to be the most likely scenario), investors will be able to relax for a moment and recalculate a course.
The vehicles and various products in the USA
Source of the graph: Bloomberg
| Is the good news that the recession is on its way?
According to what I wrote above, all that remains is to try and assess the chances that the Fed will soon be convinced that it is possible to change direction. While inflation is still very high and the labor market is tight, we can certainly see signs that the scenario we have been drawing for a long time, in which inflationary pressures will gradually ease at the beginning of next year, is taking its toll.
The goal of the Fed’s interest rate hikes is to cause a proactive slowdown and even a recession in the American economy, which will cool the labor market and wage pressures. Therefore, the signs that the recession is indeed on the way should instill a spirit of hope in investors, because as long as we are talking about an initiated recession, which does not deteriorate into a financial crisis (and most of the signs show that this is indeed the scenario), then this is the only cure that exists for the problem of inflation.
Beyond that, on the product side, there is no doubt at all that the inflationary pressures that have existed until now will turn into deflationary pressures next year – which will sharply lower the overall price. For example, the used vehicles section (see graph) increased in the 12 months ending last September by 7.2%, so it is still inflationary. However, according to the Mannheim index, the prices of second-hand vehicles went down in October for the first time compared to their level a year ago, and not just a drop, but one of 10.4%, the sharpest drop since January 2009.
In other words, in the October index we will probably see for the first time the section making a negative contribution to inflation. Not only that, but quite a few factors support the continuation of a sharp drop in prices during the next year as well. First, the price level is still very high. Even after the drop in October, the median price is only 15% below the peak and about 40% higher than the pre-corona price, so there is a lot to go down. Second, the damage to the real income of US households is known to be acute and is expected to greatly moderate the demand side. According to the Boston Fed data, published last week, in the last 12 months 53.4% of American workers saw their real income shrink, with the median damage where it stood at no less than 8.6%.
Since the American economy is on the way to a recession and is expected to increase, it is likely that the demand side will continue to be relatively weak next year as well. If we also add to this the increase in the supply of new vehicles and the increase in interest on car loans from 4% to 6.4% today, then this is a combination of enough headwinds to support a further drop in prices during the coming year. Of course, the vehicle section is only one section of the consumer price index, but the trends that affect it affect quite a few products, especially durable products, which together already make up a larger part of the index. Therefore, it is likely that already at the beginning of next year we will see inflation decrease and in a relatively sharp manner, to the level of 4.5%-5%, which will of course make it very easy for the Fed.
In addition to all this, you should also pay attention to the expected changes in the housing section of the consumer price index. In the US, the rental market currently contributes 2.1% to inflation, and as Guy noted after the publication of the latest index in the US, it is likely that it will continue to gain momentum in the coming months as well. However, because of the measurement method (by the way, it is exactly the same in Israel as well), the housing section naturally reacts with a delay of between half a year and a year to what is happening on the ground in the rental market.
Therefore, if we look at indices that examine the actual transactions such as that of Redfin (the giant real estate agency in the US) which reported in September the first significant decrease in two years in the median rent in the US, then we can see a change in direction in the market, which is expected to come reflected in the index during 2023.
It is true that the inflation figures for the coming months will continue to be high, but it is clear that the Fed is also looking at other figures and derives hope from the fact that they may soon be able to ease their policy a little.
The writer is the chief strategist of Psagot Investment House and has no personal interest in the subject of the review. This review is not intended to be a substitute for investment marketing that takes into account the data and the special needs of each person.