Dom’s Quick Take: My Two Cents on the Bull/Bear Debate

Summer Bullish

Over the next few months, I am with the bulls (John Authers’ column explains why concentration of outperformance in a few tech stocks does not imply a selloff).

The reason for my optimism is that we are basically in a strong growth/high but stable inflation/passive Fed regime. Strong growth is shown by earnings resiliency, the Atlanta Fed GDP nowcast (my preferred aggregator of macro data), and stronger consumer income and balance sheets (the US economy is 70% consumption) – to name but a few indicators.

At the same time, core inflation has slowed relative to the 2022 high, and the Fed sees upside inflation risks as less of an issue. At the March FOMC, 11 participants saw inflation risks tilted to the upside and seven saw them balanced. By contrast, at the December FOMC, 17 participants saw inflation risks as tilted to the upside, and one saw then as tilted to the downside. 

A high growth/stable inflation and Fed macro backdrop has historically been positive for equities (and I don’t see the TGA replenishment as spoiling the party).

Fall/Winter Bearish

However, I am long-term pessimistic because I think the disinflation has been skin deep and reflects mainly the decline in energy prices. 

My preferred inflation model is the BIS’ two-regime view: when inflation is low, economic agents ignore it and inflation shocks tend to be stabilizing. When inflation is high on the other hand, economic behaviors incorporate inflation expectations and individual agents’ expectations converge to a common actual inflation level. The components of the price level become highly correlated to each other, and inflation acquires inertia. 

I believe this explains the reappearance of the correlation between energy and core inflation since the pandemic. That correlation was strong in the 1970s and 1980s, disappeared in the 1990s and 2020 and made a comeback in 2021 after the CPI crossed 5% (Chart 1).  Paradoxically, due to the return of high inflation, falling energy prices have lowered core inflation. 

In addition, the decline in headline inflation has allowed workers to increase their share of income without an acceleration in nominal wage growth. I think this absence of wage acceleration is like the proverbial hound that did not bark, but obviously that is not the view of the Fed! To the contrary, it has given cover to the FOMC doves to keep waiting yet a little while longer for a much prayed for ‘immaculate disinflation.’

As Viresh has explained, there is a good chance that energy prices could perk up in the latter part of the year. When that happens, likely during fall/winter, I expect headline and core inflation and wage growth to accelerate. This will force the Fed to move to a more aggressive tightening path, with adverse consequences for equities.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Photo Credit: depositphotos.com

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