Surveillance: Fed Tightening with Carpenter

y soldly above one o eight. We're watching sterling John and I one eighteen thirty one. We will speak to him the day before Paul speaks and a data dependent FED will change to next Thursday. Seth Carpenter of Morgan Stanley will join us. We will be in Jackson Hole. He'll be cool common collected on the East Coast. We're thrilled at Mr Carpenter could join us this morning. Seth Carpenter,

your note is frightening. The brewing storm. You talk about it sounds like Wins of War from nineteen thirty nine and all defined the brewing storm. What what what is the distinction now of this August of two thousand twenty two. Yeah. I mean, I think for markets, August is always a little liquidity moment, so you're gonna see all sorts of choppiness there. But I think when it comes to the macro front, you've got three key economies in the world.

You've got the U S, You've got Europe, You've got China. China we know is struggling. Uh they had a contraction in Q two. They've got this burgeoning housing problem that they're trying to solve. The PBC just had to ease policy again in a bit of a surprise move. Now we think Beijing, through various sorts of policy, both monetary and fiscal, will come to the rescue. But the question is when does the inflection point happen and we get

a big rebounder as it's soft shifting to Europe. Right, You've got this restriction and gas flow from Russia as invasion of Ukraine that's crippling the European economy. We have a baseline view of a recession in Europe. Q four being outright contraction. Q one being another contractions and that's not a great look. So the US right now pretty solid. We got the retail sales report in line with our expectations. The consensus a little bit. Non farm perils was super

strong and over five thousand. But is good news good news in this case, I don't know. The fight has been very clear. They need to slow the economy down, so the stronger it is now, the more hiking they have. You know, we always look at our guests and we try to figure out from the back of their bookshelf Seth Carponer what they're actually thinking. And it's good to see that. You've got Tony Krissenzi of pimcost Stagum's Fixed income Bible over your right shoulder. What does the bond

market tell an economist like you? I mean, I think right now the bond market is really struggling to read the tea leaves about what's happening. We saw this sense of relief in markets, I think when we got CPI tipping over, and when the market heard the Feds saying, gosh, we're taking a balanced approach. We care about both the

growth in the economy and inflation. But what I think the market didn't hear enough of is the way inflation over the next two years is going to come down to the Fed's target is only if you get enough slowing in growth, and so as a result, you know, we think the peak rate that the market is priced is about right. But the cuts in the market that the market has in place for a lot of next year, uh,

that's not really consistent with our forecast. Well on that point set the market thinks that the FED is going to get to the terminal rate and then very quickly thereafter come down from it. We've been having the conversation all week as to whether or not that's really true. How long do you think they have to stay up there? I mean, our baseline forecast is that they're there for

a year. So they get to the peak grade in December, and then the first very grudging you know, basis point easing off in terms of a cut comes a year later in December. Ree. I mean, the short answer is no, one knows for sure. We think the US economy has a fair amount of momentum behind it, and more importantly, as I was saying before, they really do need to

slow things down a lot. They need to take job growth from five hundred thousand per month down to something closer to a hundred thousand per month or maybe even a little bit below in order to get that real underlying trend inflation down, So they're gonna have to stay tight for a while. How low do you think realistically inflation will get? Is three percent going to be the new two percent? So sadly this is where you get the eggheaded economists talking about the two different measures of

inflation CPI versus pc UM. I think three percent on CPI is very, very possible. I don't think that that's going to be happy to just let PC inflation, which is really what they said that two percent target for. I don't think they're going to be happy to let PC inflation settle in at three percent. They'll be happy when it gets down to three percent if it's on a downward trend, but they're not gonna declare victory if it's hanging out. I sided not budging, So set frame

your and Elexantner's ex access to me. The big mistake here is the now now now of how policy is gonna move. Is this really a six quarter, eight quarter, even twelve quarter path that we're on far longer? Tom That's that's a great way of phrasing it. I think one issue that's important for everyone to keep in mind, is that monetary policy does in fact work with the lag. We know that markets are pricing in now at peak grade that's close to where we think that peep grade

is just over three point six percent. But in terms of the actual drag on the economy from UH that policy stance, it hasn't shown through completely yet. We've seen it in housing, that's important. We're going to see it a bit in durable goods, and we'll see it more endurable goods. But that still has to play out. So it is not what's going on right now that matters.

It is, in fact, as you say, what happens over the next two quarters, over the next four quarters, and yes, ultimately over the next six how will corporations and their investment react to a pernicious four or five percent inflation in the United Kingdom? Everyone from lisz Trust to Mr Sunac suggests there's been a dearth of investment in the UK. Are we going to see a dearth of investment in

the United States? So I don't think we're going to see a dearth of investment, but we we should, by all all expectations, see a slowing in in that investment spending. What you see in the macro data is typically business investment spending tends to follow the overall trajectory of the economy.

And so if we're right that the slowing and housing, the slowing and durable good spending, and with it the slowing in jobs leads to an overall slowing and aggregate demand, and absolutely businesses should be looking around and saying, Okay, there's gonna be less of a need for that sort of aggressive investment spending. I don't think it drops off of a cliff. I don't think we're going to have

a massive shortfall. UK has its own idiots and credit issues, let's say, but we should see things starting to slow down as aggregate demand slows down, and businesses pay attention to that. So if we all know I read a lot of Morgan Stanley research, I shared a lot of it on this program, I'm wondering, set of course you'd say that, Seth. I'm wondering when I received that note from you that says global recession that's the base case.

How close are we to you sending that note. Gosh, the SEC would get mad at me if I previewed forthcoming research. So I will say that we we We definitely had a global recession as one of the scenarios when we put out our mid year outlook in in April, and we are very much moving closer and closer to that scenario. I mean, the gas situation in Europe matters a lot, and we have a recession in Europe as

our forecast. There's clear downside risk to China from their housing situation, something that's worse since we wrote that note. So we're moving in that direction. I think it's too soon yet the recession. But John, what just means Carpenter's got a published before next Thursday. We needed the fall. Jackson Hope a seth also to catch up sir as a White set copp into that of markin Stanley dry An Interview of the Day, Jane Folly joins us an out from Robbo Bank. Jane, let's get right to it.

John's got a lot of technical questions. I've got one that's just simple. There's a log vector of weaker, weaker work, weaker sterling, and then it rolls over at what level is the tipping point you have in your head where things fall apart? For Governor Bailey, Well, to be honest, it's an awful lot depression on Governor Bailey already sent me from matt List. Trusty looks as if she could

be the next step prime minister of the UK. But I think we could be heading down to one fifteen, maybe one fourteen on on cable and and that would add and I mean to interrupt, but if we go to one fourteen, is that a trend and a controlled trend or the things to borrow phrase from politics unraveled, you know, I I think if we're at one fifteen fourteen, A lot of that, actually you really does depend on on the dollar, and specifically on euro dollar, because what

we're seeing at the moment is that if euro dollar dips, and of course it's been dipping, it's very difficult for cable to hang on in there has been dragged lower too, So a lot of this is a dollar move, certainly over the last week. But that said, there is a lot of sterling weakness. You know that the pound has really been suffering I would say for the last four or five years since the twenty sixteen Breakxit referendum. Sterling has never really been able to recover. Investment has never

really been able to recover. Investors are still quite sept skeptical. I think of the prost Brexit UK economy and the government that we've had hasn't really been able to convince investors to come back. And you've got to bear in mind that the UK has got a current account deficit and if there was overseas savers are looking in at

the UK and they're not liking what they're seeing. Well, you know, sterling is likely to a just lower and I think that's the situation that the pound finds itself in and and without the growth with at the investment, I think sterling could remain you know, pretty weak for a while. Jane, the Great Heights make a difference. Are you saying they don't? I don't think they do. I mean, look, if you go back to May, we had admittedly and as expected to interestrate hip then it was the twenty

five back then in May, and sterling really dove. And the reason it dived lower was because the Bank of England at that point in its quarterly review down graded the inflation, sorry down graded the the growth number. Um and if we go if you fast forward to to to August, the next quarterly review, this is the one where we have the governor saying we're going to have

a five quarter recession. And again, you know, Sterling reacted badly because you know, if we think that a lot of this is about the lack of investment growth in the UK, um investors need something to hang the hats, and they wanted to see improvements in productivity, improvements in growth, and that's not what they're seeing right now, and that's I think why Sterling is really so so weak. Well in the b O, we obviously is in a tough spot in that regard, but the e c B is too.

There is a question of whether they can do anything to support the Euro if we get a break of parody once again, where's the bottom? Well, you know, I think if we were to break paroity, I think there's every reason that we could fall quite fast, maybe towards certain and there's some options that below there which could

trigger U such a move. And I think it's I think you're right really to make some comparisons between at the Bank of England and where the ECB could find itself perhaps in a few months time, because if we look at the situation in the neurozone, it's all about energy.

We know that if we do have, say, blackouts in Germany's industry groups over the winter months, if we do have the market panicking about what that would mean for that for growth or lack of growth in the Eurozone, But that wouldn't necessarily do anything to bring inflation down. So we could have a hawk ish ECB and that sort of scenario, but that wouldn't be a scenario which

we which which would be beneficial for the euro. So again, it could be that the growth worry overtakes the outlet for the currency over and above the whole business of the central bank. Well, and there's a question of causation here is it? Is it weakness of the euro or strength of the dollar? More so? And on that point, where do you think the peak is on the d X Y Well, you know, I think we're going to remain strong at least for the next six months. And

I think you're right. For instance, if we look at the G ten currency performance today, actually think the Euro is holding in relatively well, actually better than than many of the other G ten peers. So this is about dollar strength right now. I mean, of course, is euro weakness in there, and the energy story is really important,

but this is about dollar strength. And and to be honest, I think for a while that the dollar has got these two pronged factors driving in and the first is of course the FED and now the markets again thinking that the FED could be higher for longer um in terms of interest rates, that maybe it needs to keep interest rates higher next year, next year in order to to to really get that inflation back in the box.

But the other factory is a called safe haven. And don't forget at the start of the week we had a lot of poor Chinese data. Now that's really bad for emerging markets, it's really bad for world growth um, and and that is you know, part of the attraction of the dollar, this safe haven flows. So I think both of those things together have been pushing the dollar higher, and I don't think the dollar has done yet. Jane. With that in mind, what's the downside on a currency

pair like cable? Now, once you take out the mitchell I lows, what next? You know? I do think one fifteen, you know, we could certainly see there. But it does depend on where euro dollar it goes, because there's a bit more of an equal battle at the moment between the poor fundamentals and the sterling and the poor fundamentals in the EU. So I think that the guide here will be your a dollar. John of her wonderful comments, Jane'll love this. I just did a log interpolation of

euro sterling over the sterling dollar. You're ready, John, one eleven, one eleven. If you get sterling, the strengthen against euro is misfolly talked about it roughly interpolates to a one eleven. Jane Foley of Rabbit Bank, jank awesome to catch up right now an important interview with Patrick Armstrong, ce I O of Pleuri Meat Wealth. Patrick, I want to cut to the chase. The level of gloom now approximates the level of gloom of early June. Can you be long equities?

I'm net long equities where I have completely flexible mandates. Um, we've got one fund where I can be short or long, and we're long net. So I've got actually fifty of my portfolio on long equities, and I've got thtent in shorts. And there's some extremely cheap talks out there that I've not seen in decades. Really, like a company like Moler marrisk is trading it less than two times earnings today it's paying me a twelve percent dividend deal, it's buying

back shares. It's probably gonna pay a special dividend it will announced later this year. So it's got a lot of cyclical risk. Rate rates are going to collapse. Market says they're gonn a collaps starting today. I think those rates don't collapse until we're into next year. I think supply chains remain challenged, a lot of bottlenecks. There's an amount of goods in the world that need to be shipped. There's not enough shipping capacity. Oil and gas stocks exact

same scenario, and maybe not to the same extent. Markets pricing and oil plummeting in the future. I don't know if it will. You've not seen to demand destroyed yet, supplies not coming on stream, and these companies are just producing massive cash flow every day. The Patrick, it sounds like you're still long inflation. Well, I think inflations plateaued in the United States and the strong dollar. Lower commodity prices are going to see your on your prints continue

to go down. UM in Europe. In the UK, UM commodity prices haven't fallen in the same way because the currencies have fallen, and electricity prices are jumping in European natural gases moving higher. So I think you've got a lot of stagflationary forces that are remaining in Europe, where the US has probably passed the worst of that. Patrick, Just how bad is the story in Europe and how bad is it relative to the price at the story

in the market. I don't think the market's really priced in how bad it can be in Europe unless something dramatic changes where you do get Russian gas into Europe again. Manufacturing is going to slow, hiring is going to slow, There's gonna be brownouts and blackouts, people told to work from home. All of those things are negative for the economy obviously, And it's just Germany is going to solve its reliance on Russian natural gas, but it's just not going to be in two in the winter of three.

It's going to be another year and a half before they can get all the other measures in place that they're not reliant on Russian natural gas. On the subject of Europe, Patrick, one of the lines in your note that stood out to me was the market has the ECB hiking while the FED cuts in dot dot dot. No way what do you think is more likely that neither is hiking next year or that both are. I think neither will be hiking probably when we get to three.

The U S economy is slowing, it's still growing, the employment situation still look pretty robust. That small companies say they're they're having trouble filling job opening so, um there's anecdotal evidence about layoffs coming the p w CS p WC surveys talking about half our companies doing layoffs next year, but companies aren't being able to fill the job openings

they have. Um F, it's gonna be hiking in September, maybe once more after that, but while the economy slows and the rest of Europe falls into a deeper session, I don't think the Fed's going to be doing much in terms of hikes next year. But there's no way the e c B will be hiking with that backdrop. Well, I understand how the data could lead to a picture of the federal reserve backing off, but does that leave the job on inflation undone? Um? Yeah, So Powell characterized

where rates were after the last hike is neutral. I don't think that could have been scripted. I don't think it's at neutral. I think if we do another seventy five basis points, you can plausibly say that's at neutral. Um, if the economic situation does weaken in the rest of the world, you've got a really strong dollar that continues to mute out inflation as well. So strong dollar means all your imports are a little bit cheaper, and that

is disinflationary. So you can see that scenario where the Fed doesn't have to hike next year just because the dollar strengthening and the rest of Europe is probably in a pretty bad economic situation. Patrick, how useful is this conversation around neutral. It's such a fuzzy concept, and they're talking about a short run neutral level, a longer run

neutral level. How useful? How valuable is that conversation right now? Well, if you get any insight onto what the Fed thinks is neutral, that's very important because that's the guy that will guide you on where they're going to put policy. I don't think Powell believes it's at neutral right now. Um,

you've seen a lot of liquidity in markets. You've seen meme stocks rallying, you've seen no Learning's tech rallying, and you've not seen the FED meaningfully reduced its balance sheet, which is the other thing they indicated they would be doing, which isn't really happened yet. Um, but where neutral is is something no one will ever know. Even looking historically, you never know exactly where it is. But it does guide to fagine what they're trying to achieve while they're

I guess driving half blindfolded. Pat check got a catch off set as a wise Patrick compstrong right now on the airlines, and it is something we've all got our stories about trying to get back to travel, trying to get back to normal. It's not, say Seth Joins, US Airlines Managing Director Ramon James Savy. I want to get this out of the way right now on a bi hold cell basis, which is the American airline to believe in over the next three to five years. Which is

a stock that's getting it right. Hey, Tommy, I think Delta is probably a good stock to o and here there's a lot of uncertainties. Is a cyclical sector, but I think you've got quality. They're a good balance sheet and customer service that's returning. So that's probably my colleagues, Savvy Paul Sweeney has got me into looking at the app where I can watch the airlines take off. Last night at Newark e w R, I basically saw a

controlled chaos. There were seventeen planes, imperfect weather trying to get up in the air. How did we get here where the actual physical airports are a mess? The issue with the Northeast though, is and then this has always been an issue, is it's and you look out, it's perfect weather. But whether in Pennsylvania, you know, the weather in the whole corridor matters to the airport. So it's

it's long being a frustration. Um And and on top of that, you know you're you're layering on more recently air traffic control staffing that's that's lower than in the past. You're you have kind of just across the supply chain at the airlines and the airports. Um, just staffing levels that aren't you back to the productivity that we saw pree crisis. Hopefully, as we kind of go through the following months, m hiring picks up, people gave more experience,

some of these issues should result. But unfortunately the Northeast airspace is a longer term issue that needs to be resolved and maybe using next generation air traffic control systems. Well, and of course that's not just a US story, that's a global story. When you look at what's happening with airports and airlines in Europe, the easy Jet pilot strike in Spain beginning today lasting three days. We know what's been going on at heath Throw with everyone from the

people on the tarmac on strike. As we talk about how fuel pressures have come down a bit, what about the wage pressure, So are those now going to be picking up as the people employed by the airlines dependent demand more because of inflation? And good point, Kaylee, because and that's that's probably going to be different, different on this side of the Atlantic versus the other side, just the way the labor contracts work. But you make a

really good client. And in the US last year you had a lot of the gay pagents rampage ins where they were struggling to staff and and so you saw a lot of wage increases there about five increases for entry level positions. But that's a very small portion of

overall airline labor cost. What we haven't really seen is flight attendants, pilots, mechanics, those contracts that it became amendable right around before COVID or right around COVID, which usually would have been amended by now that hasn't gotten done yet. We think it will get done in the next twelve to twenty four months, and you're probably going to see pretty big wage increases there, and so kind of it's still a big cost increase yet to come for for

airlines here. Okay, so obviously, so that's what the airlines are paying their people. Let's talk about what me and everybody else is going to have to pay to get on the plane itself. Have we seen peak fares and pricing powers at all downhill? For here? I think we've seen peak fairs for the reason that, you know, earlier in the summer you had this kind of a perfect storm of you know, for for various reasons, capacity that was being constrained and and the capacity that was probably

about ten percentage points below demand. And as we go through I think capacity is finally going to catch up to demand. It also happen at a time where fuel was you know, it doubled in a in a very short period of newly doubling in a short period of time, and you have seen fuel called back a little bit now that will be somewhat offset by labor costs that

are coming. But I do think you're not going to see the level of pricing that you saw earlier this summer, but because of that labor class, I think it will still be somewhat elevated. So I mean, I want to go small here. I want to go from Grand Forks, North Dakota, where you schooled, eighty two miles south to Fargo. If I want to fly from Fargo to New York, it's almost cheaper to go to Minnesota to Minneapolis to fly out. Is American aviation given up on smaller cities?

Not completely? And I think Fargo is probably going to continue to have service, But you're right, there are these pockets of areas that the airlines are struggling right now because the pilot supply to two serves. And I think that will get resolved over time, but it is for small cities. Uh, you're going to see maybe less frequency UM or in very small city so as instances maybe no no service, and that the service getting dropped and the result is a pilot supply issue UM and a

pilot cost issue. These are kind of fifty seed aircraft that it really gets hard to spread that fixed cost out as as pilot the wages move up, Sammy. Awesome to get your thoughts on this industry, Sammy said, there of Raymond James and industry we've all got an opinion on. Right now. This is the Bloomberg Surveillance Podcast. Thanks for listening.

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