Swimming Along the FX Channel...
Goldman's inflationary framework, an update on gilts and oil, and how economic adjustment may increasingly come through the FX channel...
Welcome back to Market Making, your weekly dose of sell-side research and insight.
⏱️ Estimated Read Time: ~31min
✍️ Word Count: ~6,700
📚 This week’s Reading List has been updated
Part 1: Goldman’s Inflationary Framework
While many in the general public think that a recession is inevitable across the developed world (or that we’re already in one!) the base case forecast from Goldman - along with most other major investment banks - is that a recession will be skirted in the United States, Canada, and Australia with the UK already being in one and the EU likely falling into one in 2023.
However, whether a recession will eventuate largely hinges on just how high you think the terminal rate will need to go. And as that terminal rate goes up, things start to begin to ominously creak and crack, just like when the pressure goes up in a submarine that’s descending ever deeper.
Importantly, it’s not just a country’s given terminal rate that matters, but also the level of divergence that develops between the terminal rates of various countries (as I covered last week when discussing the macro 3Ds). When this divergence grows sharply - causing FX and credit volatility to expand - this provides more room for something to break in global markets, which can have an unpredictable ripple effect.
Anyway, this week GS published a “progress report” on whether the US, UK, Canada, and Australia can bring down inflation without a recession. To set the stage, here’s the four-step process GS set out for “taming” inflationary pressures:
In our framework, taming underlying inflation follows a four-step process: 1) central banks raise policy rates to tighten financial conditions and bring GDP growth below potential, 2) slower GDP growth reduces labor demand and helps bring an over heated labor market into balance, 3) a less overheated labor market means slower wage growth that is ultimately compatible with 4) a reduction in core inflation to target.
…and here’s where we are today. Take note that the hawkish turn by the Fed at Jackson Hole has had the impact of significantly tightening financial conditions after they materially weakened during the summer.
Now obviously what GS has put forward here is a relatively simplistic framework. So it’s worth taking a moment to think about a few things that contribute, or act in tension, to this little framework.
Asset Price Impacts
The first thing that should immediately come to mind - which has certainly been observable over the past six months - is the impact that raising rates and tightening financial conditions has on asset prices, and how that feeds into reduced future economic growth (which is obviously the Fed’s aim with raising rates).
While it can seem like economic growth drives asset prices, not the other way around, there are three primary theories on how steep declines in asset prices can impact future economic growth.
Part of the reason while you’ll hear about these less - especially from economists - is that it’s so difficult to isolate asset price impacts (i.e., determine how much asset price declines are really driving a specific observable outcome).
However, when you’re dealing with markets there are many things that seem self-evidently true - and that are thus worth thinking about - that are hard to isolate or place into an econometric model along more measurable things.
Theory 1: The Negative Wealth Effect
Let’s be clear: given that monetary policy can’t really fix supply-side issues, central banks are raising rates in the hope of creating demand destruction by whatever means necessary.
When it comes to the consumer-side of things, one way to reduce demand is just to, well, make people feel poorer. If you’ve observed your home value go up by 25% over the past few years and your 401k go up by 30%, even if your real wages are flat most will be more inclined to buy more goods (in particular, more luxury goods). However, if your net worth is declining - even if your real wages are flat or rising a bit - most will be more inclined to tighten their belts a bit.
Theory 2: Capex Reductions
Goldman had another report out this week citing that on earnings calls companies were forecasting large reductions in capex (capital expenditures) moving forward.
Goldman attributed this to worries about a recession, but I have a not-so-sneaking suspicion that equity price declines play just as large (if not larger) role in future capex spending.
Here’s how I think about it: let’s imagine you’re the CFO for some large company and you’re spending $100m on capex a year. Your equity price has declined significantly and your shareholders are irritated. Further, you’re irritated as well as a non-trivial amount of your compensation comes through stock, not cash.
You know that one way to boost up your share price is to cut “unnecessary” capex, as this will boost your unlevered FCF and make your company worth more from a discounted cash flow perspective.
So, you say on earnings calls that your planning on reducing capex. However, if you say your reducing capex because you think it’ll boost your share price then that’s kind of a finance faux pas. It may be true, but it’s just not something you say.
Knowing this, you say that you’re worried about a recession, which is not something anyone will raise their eyebrows at because that’s a conventional rationale.
Theory 3: Access to Capital Markets
Finally, something that is axiomatically true is that a company’s equity value is a valuable form of corporate currency. It’s something that can be used - in conjunction with cash and debt - to do mergers or to justify raising more corporate debt (as there’s a big equity cushion coming from your high-flying share price).
However, as your share price declines, your access to the capital markets - especially if your an unprofitable company or a high-yield issuer - begins to dry up. This is largely why you hear so much about startups laying off employees, getting costs under control, etc. these days.
When asset prices are flying high, people feel more comfortable putting additional dollars in. When asset prices fall back to earth - even if they do so in equal measure to peers - that additional funding dries up and companies need to try to get lean enough to survive on their own.
Headline CPI Impacts
Goldman’s framework carefully sidesteps how components of headline CPI can act as a catalyst to core inflation (headline isn’t referenced in step 4), despite all prior steps still being true.
For example, even in an environment of higher rates, slower growth, and higher labor market slack, if you have higher energy prices due to supply constraints or shocks of some kind then that can bleed into core goods and services (remember: if companies have higher input costs, they’ll pass along as much of those to consumer as possible!).
This week we’ve seen OPEC announce a steeper than anticipated cut that made Goldman’s higher oil call from last week - that we discussed last Sunday - seem quite prescient. If we’re living through a $110/bbl environment through winter, then one would expect core inflation to be sticker than most economists are projecting.
Note: Of course, if oil does go up to $110/bbl or higher, that’ll also revive headline CPI as well from it’s more depressed current state — almost all of which was attributed to oil price declines.
Anyway, with those things in mind, let’s turn to Goldman’s four-step process…
Step 1: Progress on Slowing Economic Growth
GS is forecasting 2022H2-2023H1 growth of 0.9% in the US, 0.6% in Canada, -0.6% in the UK, and 2.2% in Australia. Noting that rate-sensitive areas of the economy (i.e., housing) have slowed significantly already.
So we have made non-trivial progress in slowing the economy and the US, Canada, UK, and Australia are all growing below their potential rates.
Step 2: Progress on Rebalancing Labor Markets
Like Chair Powell, Goldman loves looking at the job-workers gap to assess labor market tightness. There’s a number of problems with looking at the total number of available jobs (i.e., firms fishing for potential employees, but not actually hiring anyone if they aren’t a clear and obvious fit).
However, one reason that GS likes this measure - beyond it being one looked at by the Fed, which is informative from a rates path perspective regardless of its a good measure or not - is that they’ve developed models to correlate the declining jobs-worker gap with wage inflation.
Per this model, the jobs-worker gap in the US has fallen 50% of the level required to be consistent with the Fed’s inflation target (this is thanks largely to the August JOLTS report — which is itself a very messy dataset, but definitely surprised the market and caused a rally to ensue earlier this week).
Ultimately, the goldilocks scenario envisioned by the Fed is that if job opening decelerate significantly, that’ll reduce wage pressure as workers feel they have less bargaining power given more limited alternative job openings, and this will allow wage pressures to cool without a rise in unemployment occurring.
If this seems a bit farfetched to you, I’d be very inclined to agree. Especially since job opening declines are coming off historic highs that have no real comparable.
Step 3: Progress on Reducing Wage Growth
If you’ve followed my writing for awhile, then you know my views on wage growth vis-à-vis inflation: if wage growth isn’t brought down significantly, then there is no plausible path for hitting target inflation.
Goldman’s own wage tracker has the US moving sideways the past few months at 5.5% — although alternative measures like the Atlanta Fed’s are much higher at 6.7% and likewise running sideways.
In last week’s post I discussed that wage growth can be above the inflation target - given that not all personal income comes from wages - but that it needs to come down significantly. According to Goldman’s model, it needs to come down by 1.5% to 4% in the US to get inflation near target by the end of 2023.
My intuition is that it’ll have to come down by more than that, unless rates are high enough that debt servicing begins to hog up quite a bit more of personal income (i.e., core inflation in goods and services comes down because, despite 4% wage growth, most of those gains are going to paying higher debt serving costs).
The issue with the US relative to Canada, the UK, and Australia on this latter point is that a significant part of their mortgage markets are floating, not fixed, whereas nearly every mortgage originated in the US - especially over the past two years - has been fixed at a long duration.
As a result, in Canada, the UK, and Australia interest rate increases naturally lead to many consumers pivoting from buying goods and services to servicing their enlarged indebtedness (it doesn’t hurt that Canada, the UK, and Australia have significantly enlarged housing prices relative to earnings).
Regardless, here’s the issue: you have to really squint to see much progress when it comes to forward-looking wage surveys. While wage pressures may have peaked, there hasn’t been a precipitous drop and I doubt we’ll see one without reasonably large labor market slack being introduced (i.e., an increase in actual unemployment).
Step 4: Progress on Curbing Core Inflation
So, where does all this lead us? Well if it seems like a mixed bag to you, then Goldman agrees. While economic growth is undoubtably running below potential and job openings seem to be falling (although its a messy data series!), wage pressures still are stubbornly persistent and inflation still remains very elevated.
Of particular concern to the Fed - or any other central bank - is when inflationary pressures become broad-based. You may recall that the “transitory” rhetoric we heard earlier this year centered around how inflation was in just a few categories - imported goods and then energy - and that it wasn’t as much of a concern given that it wasn’t wide spread.
Goldman ends their report with a reasonably dower chart illustrating that over 50% of inflation categories are running above 5%. When inflation is so widespread, it becomes more likely that it’ll become embedded and harder to stamp out without significant economic pain having to occur.
Further, when we look at where we are today with inflation, we still need to reconcile that the decline in headline inflation - and likely some elements of core - have been driven by lower commodity prices, which have now begun a steady march up once again (see the next section of this newsletter for more on this).
The rates and equities market this week have entertained, once again, the notion of a Fed pivot incoming. This has been pushed back hard by Fed members in speeches this week, because they recognize that if inflation begins to turn back toward the upside, even if it’s due to an exogenous energy shock, then rates will need to be reset even higher, financial conditions will deteriorate to a precarious level, and a recession will become truly inevitable.