Investors have been focused on inflation for the past 3 years, but the Fed is now shifting its focus to full employment. Despite the return to favor of risky assets, in an uncertain economic environment, Loomis Sayles believes that investors should remain cautious, to guard against potential unpleasant surprises.

For the past 3+ years, investors (and the Fed) have largely ignored the "full employment" side of the Fed's dual mandate, and instead, has been laser focused on the Fed's ongoing battle to rein in a damaging surge in inflation.  Between the COVID-induced supply side constraints and disruptions, super-accommodative central bank policies worldwide, run-away fiscal stimulus in many developed countries (and in the US, in particular) and finally, post-COVID "revenge spending", it was no wonder that demand would ultimately outstrip supply.  For a period of time in the early 2021 period, one of the buzz words was "transitory" -- as in "this inflation we're all experiencing globally will be transitory".  To make matters worse, global central banks and fiscal authorities were hesitant to throttle back the monetary and fiscal support for the then-fledgling recovery.  In the US, in during much of the decade pre-pandemic, monthly inflation prints of 0.2-0.3% (which annualizes to a historically acceptable 2.4-3.7%), were fairly typical. However, by early Spring 2021, monthly prints started to push towards 0.4 to 0.6% and then continued higher, ultimately coming in at a disconcertingly high 0.9-1.1%+ monthly pace by early/mid-2022, with peak year-over-year (YOY) headline CPI ultimately printing as high as 9% in June 2022 before starting to moderate.  The Fed did finally respond with 525 bps of policy tightening from March of 2022 through July 2023.  And it has continued to reduce the size of its balance sheet through quantitative tightening.  Now, two and a half years after the start of the tightening cycle, we're back to "respectable" monthly inflation prints.  And on the Fed's preferred inflation measure, Core PCE, we're now finally trending back towards a mid 2% level.  Phew - mission accomplished...  or is it?

In terms of the reaction function of the Fed, its focus has now transitioned from "price stability" back to "full employment".  Fed Chair Jerome Powell has made this abundantly clear in more recent speeches and policy statements.  We've been told for months that the Fed views a 5.5% Fed Funds Rate as restrictive.  And as inflation eases even further, over time, that 5.5% nominal rate has become even more restrictive.  And we also know that policy works with a lag.  At the July FOMC presser and again at Jackson Hole, Powell made it clear that the start of policy easing is likely to be at the upcoming September meeting, but that the Fed remains "data dependent".   So does that mean that the Fed is looking for additional improvement on the inflation front?  Not necessarily.  The "shelter" component of core inflation, in particular, has been "sticky", but given the signaling from the real time rents data, we expect that also to start trending lower, ushering in a core inflation rate of around 2% by early next year.  Whereas last year, when the Fed’s focus was primarily on inflation, now it’s reversed, and the Fed is much more focused on economic growth, with employment being the key variable.  The jobs data continues to be solid, helped along by an ample supply of new labor force entrants that has allowed wages to moderate more recently.  But the trend in unemployment, has become much more concerning in our opinion, with U-3 pushing up from a trough level of 3.4% around a year ago to the current 4.3%, as reported by the Labor Department in May.  So when the Fed suggests that it remains "data-dependent", of course the incoming inflation data remains important.  But the economic data, which helps give us a read on the health of the economy -- particularly the jobs market, will be key towards determining, not when policy easing starts, but at what pace and ultimately for how long and how much policy easing we might get.

As investors, we're interested in how this policy shift by the Fed may translate into market pricing.  Risk assets (equities as well as corporate credit) have been on a tear, with stocks currently at or near record highs, and IG and HY credit spreads near cycle tights, with risk buoyed by the prospect of over 200 bps of Fed easing over the next year.  It appears that markets have priced in an ideal soft landing where both bonds and stocks can rally and be supported by a more accommodative Fed.  But we have also recently experienced a (very brief) dress rehearsal for what happens when risk markets start to doubt that "soft landing" scenario and/or it morphs into a harder landing.  Just a few weeks back, US equities corrected 9-12% in a matter of days before recovering.  IG and HY credit spreads also pushed wider, briefly causing significant negative excess (and absolute) returns, before clawing back most of their losses.  The current environment reminds us of the 2019 market environment.  The Fed had just completed a tightening cycle and was pushing through some policy easing to ensure a softer landing.  Equities were marching higher and credit spreads were around these current, historically tight levels.  One could say that valuations were "full".  However no one expected COVID and the uncertainty of that period is without precedent in modern history.  But the magnitude of the market disruption was magnified by then-complacent positioning.   Today, with the relatively solid health of corporate and consumer balance sheets, we think few investors expect a harder landing for the US or global economy.  But when markets appear to be priced for near perfection, investors don't typically react in a very orderly manner when they get surprised.  Unfortunately, the world has been feeling a bit more precarious more recently - land wars and potential trade wars, geopolitics, a significant China slowdown, and the US elections late this fall are all potential sources of market disruption -- and those are just the "known unknowns".  On the fixed income side, one positive is that all-in yields remain fairly attractive relative to more recent history.  Conversely, the incremental yield potential for going down in credit quality versus Governments looks far less compelling than on average historically.  Therefore, we continue to advocate for an "up in quality and liquidity" bias to portfolio construction, which could potentially provide more robust capital preservation in the event of a growth scare or risk event, as well as also providing an investor with additional liquidity to re-engage in risk markets at potentially more attractive prices. 

Written in September 2024

Loomis Sayles is an affiliate of Natixis Investment Managers.