“Let me say this. It is very premature to be thinking about pausing. So people, when they hear lags, they think about a pause. It is very premature, in my view, to be thinking about or talking about pausing rate hikes. We have a ways to go.” ~Fed Chairman Jay Powell, FOMC Press Conference, 11/2/2022 “Restoring price stability is of paramount importance because it is the foundation of sustained economic and financial stability. Price stability is not an either/or, it’s a must-have.” ~NY Fed President John Williams, 11/16/2022 “Pausing is off the table right now, it’s not even part of the discussion. Right now the discussion is, rightly, in slowing the pace.” ~SF Fed President Mary Daly, 11/16/2022 _______________________________________ Markets and Macro Update After a difficult September that saw the S&P 500 Index fall over 9%, the S&P rallied over 8% [1] in October on still-unrealized hopes for a monetary policy pivot from the Federal Reserve. On November 2nd, the Fed decided to hike the Fed Funds rate by another 75 bp. In the press conference that followed, Fed Chair Powell reiterated that controlling inflation is their top priority as long as the labor market remains strong and that they are nowhere near the long-anticipated “pivot.” Though Powell indicated the pace may slow down in coming months, as 75 bp per meeting is a very aggressive pace, the Committee gave little guidance on the terminal level of rates where they would feel comfortable pausing. They instead will monitor the inflation and labor market data to drive their decisions. Following the Fed meeting, on November 10th, both core and headline CPI surprised the market, coming in lower than expected. Headline CPI rose 7.7% year-over-year (compared to a forecast of 7.9%) and Core CPI, which excludes food and energy, rose 6.3% vs an expected 6.5%. [2] This inflation release sparked a massive stock rally. The S&P rose 5.5% in one day, its biggest one-day gain in years. The 2-Year US Treasury yield dropped more than 20 bp in a single day as the market quickly started pricing in a more dovish Fed that will bring inflation under control sometime in the first half of next year and perhaps begin cutting rates back to “normal” before 2023 is over. Sounds fantastic right? Unfortunately, we don’t expect that it will play out quite so simply. Despite the “will-they-or-won’t-they-pivot” roller coaster of the past several months, our view has remained largely unchanged through the Fed meeting and the CPI print. Powell’s press conference comments, and more recent comments by other Fed presidents including the two above, indicate that not much in the Fed’s thinking has changed either. While CPI was lower than expected, the underlying constituents paint a less optimistic picture. More than half of the downside surprise resulted from the health insurance index, which plummeted for technical reasons that don’t reflect real world price declines and dragged CPI down by 0.11%. Importantly, this health insurance adjustment is not used in calculated Core PCE, the Fed’s preferred measure of inflation. Services CPI is stickier than goods CPI, which makes it more of a concern to the Fed. It was up by 7.2% in October, slightly less than September’s 7.4%, remaining near the worst level since August 1982. It is possible, though far from certain, that CPI has peaked for the cycle but there is still a long way to go until the Fed’s 2% target is reached. Meanwhile, the labor market remains very strong. JOLTS job openings were at 10.7 million in September, higher than the 9.8 million expected. [3] More jobs were added to the economy than expected, according to both the ADP Employment Change [4] report and the Non-Farm Payroll [5] report for October [6]. The unemployment rate rose slightly from 3.5% to 3.7%, still near historic lows. While reports of layoffs have increased in recent weeks, particularly within the tech sector, we don’t expect that to materially impact the broader labor market enough to change the Fed’s course in the near term. Not all of the layoffs will affect US-based workers and there remains significant unmet demand for labor from other sectors of the economy. Our base case scenario continues to be that the Fed does what it is telling us it is going to do, namely, to continue to raise rates (and hold them at higher levels) until inflation is under control, at least as long as the labor market remains tight. We also realize that the breakneck pace of rate hikes in an overleveraged and geopolitically treacherous world can (and likely will) result in “something breaking” that could force the Fed to loosen policy in response. Neither the base case nor the “pivoting in response to crisis” case is positive for risk assets like stocks, so we are remaining underweight to equities until our outlook meaningfully changes. COP27 COP27 kicked off last week on November 6th in Sharm El-Sheikh Egypt marking 30 years since the United Nations Framework Convention on Climate Change (UNFCCC) was adopted and seven years since the Paris Agreement was signed at COP21. The “Conference of the Parties” or “COP” brings together the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement in order to jointly address climate change and its impacts. Since 2015, under the legally binding Paris Agreement treaty, most countries have committed to undertaking three tasks: 1) Keeping the rise in global average temperature to below 2°C, but ideally 1.5°C 2) Strengthen the ability to adapt to climate change and build resilience. 3) Align investment flows towards lower greenhouse gas emissions. To get all 194 countries to sign onto the legally binding Paris Agreement, it was written in a way that allowed for a “bottom-up” approach where individual countries decide what actions they will take. For example, on the topic of climate mitigation each country set its own emissions reduction targets and timeline, to be revised and raised every five years. Member counties have had to submit and periodically update a National Adaptation Plan, detailing approaches to reduce physical vulnerability and to add durability and resilience to critical and public infrastructure. Now that the groundwork of setting goals and a system to measure our progress has been achieved, COP27 has the task of focusing largely on compliance and enforcement of what has already been established and trying to bring global focus to climate issues at a time when inflation, recession, an energy crisis, and war are all vying for resources and solutions. COP27 Goals and challenges [6] COP26 was the first test of the Paris ratchet mechanism, which was designed to increase the level of emission reduction for every country, every five years. Because emissions cuts promised ahead of COP26 remained insufficient to limit global warming to the agreed upon levels, the summit ended with “The Glasgow Climate Pact” calling for countries to put forward strengthened targets this year. While COP27 was not originally a major milestone on the Paris Agreement calendar, the unfinished business of Glasgow means it will now be a critical test of whether the international process can respond to the increasing urgency of the situation. Another major challenge that will be faced by COP27 is the issue of COP26’s failure to deliver on promises of regular climate finance. Developing countries are hoping developed countries will honor their commitments to provide $100 billion in climate finance annually from 2020 to 2025. So far, they have not. Grading COP Progress The Global Stocktake (GST) is the mechanism to assess the world’s collective progress towards fulfilling the Paris Agreement, happening in a five-year cycle. COP27 will host one of three Technical Dialogues as part of the 2021-23 GST.[6] The outcomes of the GST are intended to inform member countries, negotiations, and enhance international cooperation for climate action with the aim of increasing ambition. Unfortunately, as it stands the expectation of the results for COP27 are not expected to be favorable.
