The challenge for the Fed is whether it can lower inflation without triggering a recession. The
ir core problem is that gross domestic income is about one and a half per cent above the pre-COVID trend.
In other words, thanks to the fiscal stimulus and monetary support that took place at the first wave of COVID, demand has been so great that the supply side of the economy is unable to keep up, leading to substantial price increases in everything from petrol to cars to rents.
The Fed is now trying to gradually return disposable income to its pre-COVID trend. Ideally, this is done by growing the economy slowly, perhaps one to one-and-a-half per cent for a few years, until it eventually converges and inflation falls back to target.
The challenge here is that historically, the more inflation overshoots the target, the harder it is to manage the economy. Particularly problematic is that the US economy has historically gone into recession whenever energy prices have risen by more than 20% in a given year, apart from 2011.
This is because energy acts like a tax: we still have to drive to work, we still have to drive to school, and that just sucks up our disposable income. Fortunately, on average, American households have almost more cash available through their savings than they have debt. The question will be whether those savings and that balance sheet strength will be enough to weather the worst of the tightening.
When push comes to shove, given the choice between high inflation and recession, the Fed will ultimately choose recession. A soft landing is still possible, but the odds have never been worse and it is a difficult environment for investors.
For the last 15 years, we could virtually rely on a Fed put, which no longer exists because the Fed is actively trying to slow growth, which can weaken the economy and makes bond selection all the more important. There are some sectors, such as energy, that have significant pricing power, and even consumer cyclical sectors where there are bottlenecks, such as the auto sector, where you are able to pass on higher input costs.
We will avoid sectors where there is no such pricing pressure and which may face weaker demand, especially retailers, which were the main beneficiary of COVID. And we prefer to position ourselves where consumers are most likely to continue spending. This includes cars, leisure, hospitality and targeting the US consumer, which of all the world’s major economic drivers is probably best placed to weather the coming storm.