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From 2009 to 2022 inflation was low, rates were low, capital markets were open, and the optimal strategy for investors was to hunt yield.
In 2022 inflation became a problem, and the Fed reacted and raised rates, and capital markets became more challenging, and investors sold credit and equities and put money into rising risk-free rates.
Because of cumulative Fed action, inflation is coming down in 2023 and rates will be coming down and the hunt for yield will be coming back and capital markets will reopen.
The bottom line is that the ongoing covid-driven inflation shock has lasted longer than the Fed and the market initially expected, but the Fed’s commitment to low inflation is why the inflation problem in 2022 will turn out to be transitory. Investors should appreciate that we in 2023 are transitioning back to low inflation again, and the optimal asset allocation strategy in 2023 is likely to be the opposite of what worked in 2022. I discuss this in more detail in our 2023 outlook report and 45-minute video here on ApolloAcademy.com.
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Government bond yields in Europe have over the past week started to decouple from US Treasury yields, driven by rising government spending in Europe, high inflation in Europe, and ECB QT.
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The chart below is the reason why Fed Chair Powell talks so much about the tight labor market. There are 164 million people in the US labor force. And total labor demand is 169 million (defined as total employment plus the total number of job openings). In other words, labor demand is 5 million people higher than labor supply, which is why wage inflation is so strong. The solution to this imbalance is to either increase the labor supply, for example through higher immigration, or to lower labor demand for example through an increase in the unemployment rate, and this is the challenge for the Fed.
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Home improvement spending is currently at the highest level on record, see chart below.
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The number of people going to Broadway shows is at pre-pandemic levels and continues to rise, see chart below.
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On our ApolloAcademy.com you can now download our 2023 Economic and Capital Markets Outlook, and watch a 45-minute video where I walk through the outlook for public and private markets next year. The video also includes a Q&A section and it was recorded after the Fed’s meeting earlier this week.
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The Fed is not going to increase the inflation target from 2% to, say, 3% or 4%, see also Powell’s response below from the press conference on Wednesday.
GRADY TRIMBLE. Thank you, Mr. Chair. Grady Trimble with Fox Business. You’ve reiterated today and the Committee has reiterated its commitment to that 2% inflation target. I wonder, is there ever a point where you actually reevaluate that target and maybe increase your inflation target if it is stickier than even you think it is?
CHAIR POWELL. That’s just — changing our inflation goal is just something we’re not — we’re not thinking about, and it’s something we’re not going to think about. It’s — we have a 2% inflation goal, and we’ll use our tools to get inflation back to 2%. I think this isn’t the time to be thinking about that. I mean, there may be a longer run project at some point. But that is not where we are at all. The Committee, we’re not considering that. We’re not going to consider that under any circumstances. We’re going to — we’re going to keep our inflation target at 2%. We’re going to use our tools to get inflation back to 2%.
For more, see also the Fed’s official transcript from the press conference here.
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The FOMC raised the Fed funds rate to 4.5%, and their forecast is that they will raise rates 75bps in 2023, likely 50bps at their next meeting in February and then 25bps in March and then keep the policy rate flat for the rest of the year, see the first chart. The bottom line for markets is that we are getting closer to the peak in the Fed funds rate, which historically has been associated with a rally in equities and credit, see the second chart.
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I will be on Bloomberg TV today at 8:30 am to preview the Fed meeting. Inflation continues to trend lower, which is good news for the Fed and markets. But the level of inflation at 7.1% is still significantly above the FOMC’s 2% inflation target. As a result, the Fed today is likely to argue that rates need to remain high for an extended period to ensure that inflation gets all the way back to 2%.
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