Risk/reward only slightly improved but not compelling as inflation scar tissue lingers

What happened

Global markets sold off roughly 3% last Friday, the worst one-day selloff since mid-June. The market decline has continued early into the new week. The initial decline occurred following Federal Reserve (Fed) Chair Jerome Powell’s Jackson Hole speech. In a very direct speech, he refuted the notion the Fed would quickly cut the fed funds rate next year, the so-called “Fed Pivot”. He maintained a myopic focus on tamping down generationally high inflation, even if this could cause short-term economic pain. Powell pointedly referenced history regarding the dangers of prematurely loosening policy as validation to keep rates higher for longer.

European Central Bank (ECB) officials struck a similar hawkish tone over the weekend, warning that interest rate policy would need to stay tight for an extended period to tame inflation, even if this risked recession.

Our take

Fed Chair Powell’s speech is consistent with the view we’ve espoused that the Fed is unlikely to support the markets as quickly as investors had become accustomed to over recent decades. The scar tissue due to the inflation challenges of the past year is deep. Inflation remains enemy number one for the Fed. This speech reinforced a key reason we’ve been more cautious recently.

Historically, once inflation is above 5%, it has generally taken a recession to bring it back down. There are unique circumstances this cycle given the pandemic and supply chain challenges. So, while it could be different this time, elevated inflation and the Fed’s aggressive shift indicate recession risks over the next 12 months remain elevated.