The No Normal

By Eric Peters, CIO of One River Asset Management

The No Normal:

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” reminded Powell this past summer, on Aug 26. The equity market had just jumped 15% from the lows on hopes of a gentler Fed. The Fed doesn’t tighten into weaker equity markets and a contracting economy. Ever. It’s a rule. Powell changed the rule, an opportunity to win back inflation credibility. And the market listened. The swap market anticipates inflation will collapse to an average of 2.28% next year from 7.02% this year.

Hard landing. Soft landing. No landing. Investors are dusting off playbooks from the past. There is a little bit for everyone.

• Hard landing? Housing demand has fallen off a cliff. Prospective homebuyer traffic is down 49 points since the start of the year, the largest decline ever.

• Soft landing? Credit markets are showing almost no sign of strain, even in areas where activity is weak.

• No landing? There are too many job openings to talk about landings. Real wages have a lot of room to rise, and this could allow the global economy to fumble along.

The Fed keeps hiking until policy rates are above inflation. It’s a bear market until credit cracks. The Fed pivots when something breaks, and nothing has broken yet. Equity valuations are bloated, and earnings-per-share are too high. EPS always declines sharply in recession. S&P 500 EPS is tracking growth of 6% in 2022 and consensus expected to rise another 4% next year. When the Fed is easing into recession, equity markets are usually in decline. Bear-market rallies are noise, not signal. This is the hard-landing playbook.

The soft-landing playbook sees 2022 markets anticipating a recession that never comes. Inflation was driven by temporary supply constraints. The US has withstood three quarters of housing contraction. Credit markets are fine because nominal GDP is running 7.3% annualized for the year, whereas real GDP is flat. The rapid rise in the US dollar is typically tied to foreign credit events. None have occurred. The fall in inflation will give a big boost to real incomes. Policy returns predictable path. All is forgiven – global risk climbs the wall of worry.

These are normal debates in a world that is far from normal. There is no tidy fundamental equilibrium. Balance sheets add complexity, the blind spot of most investors and policymakers. Balance sheets mostly don’t matter. Those who care about them are often in the shadows of institutions, fretting over left tails being underwritten when buying credit. The Fed’s balance sheet is merely a window into deeper challenges. Reserve balances with Fed district banks are $3.13trln. It is the symbol of decades of policy preventing financial failure.

Capital was drawn to duration assets of all varieties in that world. This came at the expense of real investment. Emerging market countries were charged with filling that gap – an epic geopolitical miscalculation. And now, whatever the type of landing that lies ahead, decades of financial imbalances need to be reconciled. Markets need to incentivize a shift to tangible investment. People will hold on to their iPhones longer, keep that ThinkPad an extra year or two. You see, the landing isn’t the problem – it’s that we need to rebuild the runway.