Jerome Powell’s speech on the Monetary Policy Report earlier this week is an admission that the U.S. inflation problem is far more complicated than what the markets and the Federal Reserve had been factoring in. The “know it better than the Fed” attitude of the market has been seasoned by the pre-pandemic experiences, specially of 2019 when the Fed had to reverse the rate hike cycle following the market expectations. But those benign expectations are getting reset to a paradoxically opposite reality. 

The acknowledgement now that the terminal rates could be much higher than earlier anticipated, given the totality of economic data, is a corroboration of our January 2023 theme that "Markets are premature in pricing in Fed's leniency" and that the terminal rate for 2023 could be much higher than 4.3% assumed by the markets two month back.

The last summary of economic projections of FOMC (SEP in December 2022) had held an average dot plot at 5.2% and a central average of 5.1%. Hence, unlike the risk markets that still believes that the Fed would eventually relent, Powell’s latest communication has fortified his view that historical records caution against premature loosening, and that the Fed will stay the course till the job is done.

The points highlighted by Powell are similar to his earlier FOMC precautious pronouncements, but what appears to be another major pushback is the indication that the inflationary pressures have been higher than expected and contrary to the assumed deep recession, the economic indicators have seen a partial reversal in the softening trend seen earlier. These overlay the reiteration that there is little sign of dis-inflation in the core services category, excluding housing and which accounts for more than half of core PCE inflation.

Our analysis have shown that the level real household consumption in the U.S. could be about 3-4% higher than the post-pandemic trend, which implies that it would require not just a slowdown but a contraction to below the trend levels for the inflationary impulses to reverse. Hence, given the persistent tightness in the broader labour market reflected in a 53-year low unemployment rate, high wage inflation, net worth to personal disposable income at 7.4 times and rising leveraged spending such a scenario is quite afar. And it overwhelms the tempering fixed investment demand and housing sector activities. Hence, Powell’s assessment that getting inflation back to the 2% target is a long-drawn process and the reinforcing caution against prematurely loosening monetary policy is germane.

Thus, all said the March 21-22 FOMC meeting are likely to reset expectations with an elevated hawkish flavour which can open up the possibility for terminal rate rising to 5.5-6%. This would be higher than the 5.5% indicated by the futures market by the end of 2023. Currently, the effective Fed rate at 4.5% implies 0.1% real rate (net of core PCE inflation at 4.4% for January 2023) and -1% considering core CPI inflation at 5.5%. This is much lower than 1.6% real rate implied in the FOMC SEP of December 2022.

A restrictive regime indicated by Powell would imply higher rates, not just for 2023 but also some scaling up of end-2024 projection, which currently stands at 4.3% (December 2022 SEP). Recent discussions outside of Fed board members, who also have advocated higher terminal rate for 2023, has been around persistence of inflation at 3-4% for a long time. This could challenge the relevance of Fed’s current long-term inflation target of 2%. Thus, the possibility of persistence of high inflation could reset medium-term projection for the Fed rate as well.

What would scaling up of the ante by the Fed mean for the markets?

First, the stronger-than-expected economic data and higher rates would reverse the deep recession and rate cut expectations earlier priced in by the markets. Following the 28% rebound during the rate hike phase since mid-2021, the dollar index (DXY) declined by 12%, i.e steeper than the post-pandemic decline of 11% in response to the massive monetary policy easing. So, the first casualty of the expectation reset could be a reversal of the dollar weakening and the commodity strengthening trade.

The outlook for portfolio flows into emerging markets could remain susceptible to continued hawkish positioning by the Fed and other major central banks. In addition, markets had earlier priced in significant bounce in EM earnings due to China opening up and India’s optimistic earnings projections. Hence, disappointments on EM growth delivery vs the optimistic expectations, currency depreciation and higher interest rates in developed markets could restrain portfolio flows into EMs.

On a trailing PE basis, India’s benchmark indices (Nifty and Sensex) are currently at 49-58% premium over the average valuation of 26 global indices. We attribute the higher premium for Indian markets (low value rank of 24-25th) to superior consensus earnings expectations for Indian companies. India’s current global ranking (11-13th) is based significantly on optimistic earnings expectations and overvaluation.

But the summary of result of Indian companies till Q3 FY23 shows that non-finance companies have experienced significant decline in profits as the episodic post-pandemic bounties and low interest rates are receding. Over the past 12 months, consensus projections for net incomes of Nifty companies for FY23 have been scaled down by 10.8% for FY23E and 16.4% excluding BFSI.

Hence, we believe India’s global ranking could slip due to a) 15-20% cut in consensus earnings estimates; b) further global monetary tightening; c) above-average sensitivity to interest rates and currency volatility, and; d) potential risks from geopolitical shocks or the ongoing Adani-Hindenburg row. Overall, the risk-free 10-year benchmark G-Sec yield may continue to outperform the benchmark indices for another year, as has been the case since mid-2021.

Dhananjay Sinha Co-Head of Equity and Research, Systematix Group.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.

Disclaimer: Adani Enterprises is in the process of acquiring a 49% stake in Quintillion Business Media Ltd., the owner of BQ Prime.