Inflation readings have, mercifully, been coming down, and investors are betting the Federal Reserve is getting close to the end of its rate-hiking cycle.
But any potential re-spiral higher in prices could complicate things significantly down the line, according to Morgan Stanley Investment Management’s Jim Caron, who says he’s been fretting over that possibility.
“The risk that keeps me up at night is that we get this decline in inflation in the first half of the year, which we know is happening, but all of a sudden we realize in the second half of the year that it’s not anchored — it comes down, but then all of a sudden it starts to show signs that it may start to bubble up in 2024 and beyond,” he said on the “What Goes Up” podcast.
Caron, co-chief investment officer of Global Balanced Funds at the asset manager, spoke before Friday’s red-hot payrolls report rattled markets. Here are some highlights of the conversation, which have been condensed and lightly edited for clarity. Click here to listen to the full podcast on the Terminal, or subscribe below on Apple Podcasts, Spotify or wherever you listen.
Q: The question after the FOMC press conferences always is, did Powell not get out the message he intended? And should we expect some whiplash in the coming weeks?
A: One of the risks that I think that we have coming up over the next few weeks, is that if the intended market reaction doesn’t match what the intended statement was supposed to convey, then as is typical, there’s going to be some walking back of this.
What Powell said in the statement was viewed as relatively hawkish. And then all of a sudden he starts his press conference, and he basically says the exact same thing that he said back in December. It was almost a carbon copy of the issues — that labor markets remain tight, which is keeping inflation risks elevated. Second, despite the decline in CPI and wage inflation, it’s still too high to be consistent with inflation becoming anchored at target level.
And then he starts to talk about service-sector inflation versus the goods-sector inflation. And he said, look, we know why inflation’s coming down — durable goods, supply chains, all of these things are certainly coming down — but service-sector inflation is not coming down as fast as they like. And then he said that service-sector inflation, if we look at it, core services ex-housing he said hasn’t even started to fall. So this is a guy who’s worried about inflation. This is somebody who’s not done tightening by any stretch of the imagination.
Then he went on even further to say, wouldn’t it be a shame if just when we had inflation on the brink of being a solved problem, that we didn’t tighten enough, and then all of a sudden it started to resurge later on? That would be really bad. And to me, that is my core risk.
Aside from all the geopolitical potential risks, the risk that keeps me up at night is that we get this decline in inflation in the first half of the year, which we know is happening, but all of a sudden we realize in the second half of the year that it’s not anchored — it comes down, but then all of a sudden it starts to show signs that it may start to bubble up in 2024 and beyond. And then they have to come back in and start hiking again from an already high base.
The markets do not have this priced in. Everybody’s talking about the pivot and the expectation for rates to come down — it would be a significant surprise and really bad for asset prices if in fact that this all got turned on its head and all of a sudden the Fed said, ‘No, we actually have to restart our hiking cycle.’ So this does not sound like a person that is ending their inflation-fighting plight.
Q: So if that’s a risk that’s keeping you up at night, how do you categorize it?
A: So it’s a tail risk, but it’s a fat tail, meaning that it has a higher-than-ordinary probability for the event to occur. And I would even subjectively put that as high as 20%. So what creates that? Certainly energy prices could do that. We know that there’s been not enough production relative to the demand.
But to me, that’s not the main issue here. The main issue is the labor market. The labor market is what’s perplexing everybody. Most models really just haven’t worked in terms of trying to predict labor. Look, we got a JOLTS survey that came out and essentially showed 11 million job openings. The other is the vacancy-to-unemployment rate — there are two jobs open for every unemployed person.
So while consumer confidence is coming down because we’re hearing about layoffs in the tech sector and these big gargantuan numbers that are being thrown out there, the reality is that when we look at jobless claims, when we look at the unemployment rate, when we look at the BLS surveys and statistics, what we’re finding is that these people who are being laid off in the tech sector are finding jobs in other areas. Now, the nuance here is that the jobs that they’re finding are lower-paying.
Now I want to be very clear about this because I think this is an important point to make for 2023 — 2023 is going to feel worse to Main Street and better to Wall Street. 2022 felt worse for Wall Street and better for Main Street.
If we look at 2022, what we saw was inflation going to 40-year highs. But what we also had was job creation. People were employed, the jobs market was still very, very strong and hadn’t started to weaken. So even though higher prices were coming into the economy, what people realized is that they had a job, they could pay the higher prices, they would still go out to eat at restaurants and spend time at hotels and go on airplanes and do all these various things.
Now we’re coming to the end of this inflation cycle — at least for now. It’s starting to come down. We’re coming to the end of this rate-hiking cycle, equities are responding positively, bonds are responding positively — if you ask people on Wall Street, ‘Hey, look, things are pretty good.’ If you ask people on Main Street, they’re saying the exact opposite thing.
Click here to hear the rest of the episode.
–With assistance from Stacey Wong.
