PPH - 3 Big Reasons Why Fed's Powell Can Be Hawkish At Jackson Hole On Aug 25

2023-08-22 07:30:00 ET

Summary

• The annual economic symposium at Jackson Hole is eagerly awaited for insights into the Fed's next policy actions. Powell will likely continue to be hawkish given the still-elevated inflation and strong activity data.
• But even beyond the Fed, insights into big changes like the ongoing strain between the US and China, geopolitics and greenflation, and the ageing population are key points to look out for.
• The stock market's reaction to the event may be uncertain, but financials could be a good trading play now, and considering the possibility of structurally higher inflation, safe stocks like pharmaceuticals can be considered.

With inflation having come off and now very close to the Fed's target rate, the reserve is due a victory lap. It's unlikely that Fed Chairman Jerome Powell will take a bow at the Kansas Fed's annual economic symposium at Jackson Hole due later this week, though.

Just consider the Fed's tone from the press release from just the last month. It's still hawkish on inflation, saying "Inflation remains elevated" and that "The Committee remains highly attentive to inflation risks". Further, in keeping with this year's theme, "Structural Shifts in the Global Economy", it might even allude to big changes afoot that can put upward pressure on inflation over the long term.

Here I speculate on what Powell is likely to say about inflation and interest rates in the here and now, and also three structural (or soon to be so) factors that can affect inflation over the longer term. Lastly, I assess what that can mean for the stock markets in both the short and long term.

Inflation hawkishness to sustain for now

First, let's get into the burning question of Powell's likely stance on inflation, and from there, where interest rates are likely to go now. Not to be a downer, but I really don't see any reason for it to get dovish right now. Here's why:

• CPI inflation, which closely correlates with the Fed's preferred measure of PCE inflation, is at 3.2% for July. It's close enough to the target rate of 2% but still not quite there.
• Importantly, core CPI inflation is at 4.7%. This measure, which excludes the impact of relatively volatile segments like food and energy, is a reflection of underlying and sticky inflationary trends that are harder to reduce quickly with policy action. To be fair, core numbers have dropped in recent months, but they remain quite elevated from a historical standpoint (see chart below).

• Producer prices, on the other hand, have dropped far faster than consumer prices. In July, the PPI grew by just 0.8% . A growing gap between PPI and CPI inflation has a positive impact on profits, with margin expansion seen across companies, as I've argued elsewhere .
• Higher profits of course spillover into growth. We started the year with a high-stated risk of a US recession. Not only has that recession not happened, the advance estimates for Q2 2023 growth put the number at 2.4% , which is above the trend growth of 2.1% over the past five years.
• The Fed notes in its latest Monetary Policy Committee (MPC) meeting minutes that the labor market is seeing signs of cooling off. At the same time, it notes that "labor market continued to be very tight" and that "further progress toward a balancing of demand and supply in the labor market was needed".

What it means for interest rates and the stock markets

In other words, we can expect more monetary tightening or higher interest rates. It's likely that Fed speak has already been baked into the stock markets, though, going by the fact that economic data still points towards higher rates. This means that leading indices like the S&P 500 ( SP500 ) and Dow Jones Industrial Average ( DJI ) are unlikely to be impacted significantly by what Powell says about near-term interest rates.

However, I drilled deeper to assess what it might mean specifically for financials, which are closely correlated with interest rates. Big banks from JPMorgan Chase ( JPM ) to Citigroup ( C ) have all seen rising net interest margins [NIM] over the past year, as an example, which is an impact of rising interest rates.

It turns out, though, that over the longer term, the S&P Financials index has an underwhelming reaction to the event, with an absolute average change of 1% over the past 10 years. This isn't to say that it can't result in a notable change.

It did increase the index by 2.6% in 2015, but on the other hand, in 2017, the change was barely discernible at -0.08%. It is however noteworthy, that in the past three years, it has resulted in a positive 1.5% increase, which is higher than average (see chart below).

Based on this, from a trading perspective, it would be a good idea to consider buying big US banks. Even ETFs like the Financial Select Sector SPDR Fund ETF ( XLF ), which includes some of the biggest US banks are worth considering.

3 big inflation-impacting changes

1. The US-China strain

It might have started with a trade war in 2018 when the US imposed tariffs on China to reduce the trade deficit, which China retaliated against. But the strain with China has escalated into a security concern for the US. Last year, the US started restricting chip exports to China, citing the risk of these being used to "produce advanced military systems". Added to this are the two countries diverging positions on subjects like Hong Kong and Russia, and that's just scratching the surface. Essentially, it appears unlikely that the stress will disappear anytime soon.

Imports from China have declined by 25% in the first half of 2023, with the country's share in goods imports now at 13.3% of the US's total imports. It's also the third-biggest importing partner for the country, down from being the biggest in 2013, with a 19.4% share .

This can have an impact on inflation over time, if it isn't already, especially the kind of big drop seen recently. In fact, it's estimated that lifting these tariffs would reduce inflation by 1% over time, which is basically the difference between where inflation is at right now and the target Fed rate.

Beyond inflation, there's a direct growth impact too, with the US's exports to China suffering too. While a truce was called on the trade war in 2020, the export figures were lower than the trend by 23% in 2022.

2. Increased energy (and related) prices

The Russian war on Ukraine has had no small impact on global energy prices, with the country being the second-largest producer of natural gas and the third-largest producer of crude oil in the world. Within two weeks of Russia's attack, crude oil prices jumped by 31% to USD 127/bbl .

Energy prices have dropped since and ingenious solutions like the EU's price cap of USD 60/bbl of Russian oil, not just control the revenues accrued to Russia, but they are also beneficial for keeping inflation in check. However, recent studies still see an energy price risk. In any case, it remains to be seen what happens to energy prices if Russia's completely out of the energy equation.

A sudden pressing need for energy security, along with that to reach net-zero, has accelerated the move towards alternative energy solutions. But these come at their own price, also known as 'greenflation'.

Green energy development, in particular, requires copious use of minerals like copper, lithium, and cobalt. An offshore wind plant is estimated to need seven times the copper that a gas plant does, for instance. Even the ramping up of clean energy, like nuclear, has resulted in an over 15% rise in uranium prices in 2023 alone. This can have a prolonged effect on commodity price inflation.

3. Ageing population

A well-studied impact is that of the ageing population, but it's significant right now in particular, as I discuss here. The world is growing older, and the US is no exception (see chart below). This structural shift has been offered as one potential explanation for tight labor markets, which in turn increase wage rates. With declining birth rates and lower immigration levels unlikely to change anytime soon, this may well turn into a higher inflation phenomenon.

Policymakers are optimistic , though. Older people tend to be better savers. The most obvious effect of this is reduced consumption and lower inflation. But an increase in their numbers also means higher savings, and can actually lead to a "savings glut", which in turn will put a downward pressure on interest rates. But for now, this very structural change can be a reason for higher inflation, and for some time to come.

Making long-term investments

If based on the above factors, inflation were to remain less stable over the coming years, I'd consider having defensives as part of my portfolio. And the one defensive sector I like is pharmaceuticals. The likes of AstraZeneca ( AZN ) look particularly attractive to me, but a dip into the sector with ETFs like VanEck Pharmaceutical ETF ( PPH ), which has offered long-term capital growth and dependable dividends is worth considering too.

In summary

In sum, it's clear that there could be both short-term and long-term fallouts from the discussion at Jackson Hole this year, with a particular focus on the Fed Chair's remarks. For the here and now, the Fed is likely to remain hawkish given recent activity data and the fact that inflation isn't down to its exact comfort levels. With the S&P 500 Financials index having reacted to the event in the past three years, it might be a good idea to consider big banking stocks or financials ETFs as a trading play.

In keeping with this year's theme, a longer-term inflation discussion is also likely. With critical changes like the rising strain between the US and China, rising energy prices on Russia's attack on Ukraine, and the spillovers in the form of greenflation as well as structural changes like an ageing population, an inflation impact over the coming years is likely. It would be good to look out for what the Fed or any of the other speakers have to say about these developments. From an investing perspective, it might even be a good idea to buy some defensive stocks or ETFs in sectors like pharmaceuticals, just to stay safe in uncertain times.

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