“The Fed will soon have to face a real choice of how much it is willing to crush growth and incur the related collateral damage in an economy which has become ever more financialized," said Chris Wood during his keynote at the Gold Forum Americas.
Last week’s interest rate hike marked the US Federal Reserve's fifth increase since January. Now sitting at the 3 to 3.25 percent level, the federal funds rate is likely to rise further before the year is over.
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 Chris Wood of Jefferies Hong Kong, it's going to get much more difficult in the months ahead.
“(To meet its inflation target), the Fed will soon have to face a real choice of how much it is willing to crush growth and incur the related collateral damage in an economy which has become ever more financialized after more than two decades of excessively easy monetary policy,” said Wood during his keynote address at the Gold Forum Americas.
He attributed today's rampant inflation to money-printing pandemic policies that “paid people to do nothing,” thus stimulating “artificial demand.” Wood, who is head of equity strategy at his firm, added that when the Fed stopped referring to inflation as transitory, it signaled the entrance of an era of “structurally higher inflation.”
Regarding the equity markets, he noted that for those who were betting that inflation would continue, “clearly value has become more attractive relative to growth,” despite a brief period over the summer where it seemed high prices might be peaking.
“But right now, I think this whole dynamic — whether you're in value or growth — while it’s still relevant, it's no longer the key issue,” Wood said. “The key issue is owning stocks which generate cash and pay dividends.”
Historic indicators show recession is in the cards
Although the Fed seems to be in a uniquely precarious situation, history may be a pertinent indicator to what lies ahead. During his keynote, “Fear and Greed in 2022,” Wood highlighted the correlation between Fed policy and economic performance.
“Since the post-war era, the vast majority of federal tightening cycles do end up in a recession,” he said. “So this has to be the base case this time, but there's a risk recession is more likely to be mid-next year as opposed to the next few weeks.”
In addition to the tough measures implemented to push back inflation, Wood warned attendees that the Fed isn’t done with its combative policy strategy. “The other big negative for the equity market — apart from the fact that the Fed is raising rates — is that the Fed is also about to start shrinking the balance sheet,” he said.
Wood added that the central bank's U-turn in policy last November and the indication that it would bring quantitative tightening forward have been the two key developments in US monetary policy in the last year.
“The quantitative tightening is going to happen much sooner than I or the markets were expecting,” he said. “It's a double-whammy — monetary tightening about to commence, and the markets aren't really focused on the quantitative tightening aspects.”
Expecting a more pronounced recession next year, Wood also voiced his concern about an even more impactful economic condition stemming from the explosion of US M2 — a measure of money supply in US households — in 2020.
Using a chart, Wood explained that US M2 has risen 40 percent in absolute terms since March of 2020, but has spent much of 2022 retracting. In June, US M2 growth slowed to 5.9 percent year-over-year.
“That collapse in money supply growth is really negative for the US economy next year,” he said. “But on the other hand, you still have the inflationary pressures dangling from the 2020 explosion." In his view, that creates a "perfect environment" for stagflation.
Energy sector defensive under current circumstances
Wood did offer some positive points, including insight on where investors may find refuge from market turbulence.
“If you believe that the Fed is going to really stay the course and keep tightening monetary policy until headline inflation is under 2 percent, then I believe you can make a lot of money buying the US Treasury bond right now,” he said. However, he is skeptical that this will happen, and instead believes the US central bank will likely bow to political pressures and not meet that target.
As US M2 has reversed this year, US commercial banks are seeing loan growth, which could facilitate a softer economic landing.
“If the credit multiplier really kicks in in the US, theoretically the pickup in velocity from the banks extending credit could mitigate some of the negative liquidity consequences of quantitative tightening,” Wood said.
“I think people should understand that there's a real risk that energy is much more defensive as a sector than would normally be the case when you go into recessions and downturns,” he said. From his perspective, the fact that demand destruction concerns have caused energy stocks to correct — despite an increase in consumption — is a catalyst for growth.
“The big difference in this cycle from previous cycles is the incredible lack of investment in the oil and gas sector, which is the direct consequence of the escalating political attack on fossil fuels in the G7 world in recent years, which has created a total disincentive to invest in oil and gas," Wood said. He added that in 2021, fossil fuels contributed 82 percent of total energy consumption.
Now holding in the US$86.09 per barrel range, Brent crude spiked to an 11 year high of US$123.35 per barrel in March. For Wood, a key threshold for the fuel will be US$150 a barrel.
“The key macro point to understand is if oil goes to US$150 ... the Federal Reserve (will be) forced into tightening, and that's how you get a real train wreck in markets," he warned.
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Securities Disclosure: I, Georgia Williams, hold no direct investment interest in any company mentioned in this article.