- In what was otherwise slated to be a slow week for data last week, a
lot happened. The narrative in the market started to change from
worries that the Fed may be making a mistake and tightening too much, to
now questioning whether the Fed might be too easy and need to do more.
- Once again the culprit is inflation and inflation expectations.
Investors are starting to question if inflation will fall enough and
stay low. As you know, this has consistently been a key risk factor: the
risk that inflation becomes unanchored and the Fed needs to do more
than what's priced.
- But as they say, sometimes it's not just about the destination, the
journey may be just as, if not more important. Why? Because market
prices are often path dependent.
- Let's get into it!
The Initial Conditions: A review of risks before the journey started
- Going back to December's FOMC meeting. The
market understood the Fed to be leading the market into a recession, as a
necessary requirement to reduce demand and bring inflation lower, to
target, and keep it there.
- Inevitably, the labor markets were expected to suffer and the unemployment rate to spike. Thereby deepening recession risks.
- Many started to call for an end to the tightening cycle at 4.75% at
the Feb 2 meeting. The Fed was driving the economy off a cliff into
- Cash was at record and cycle high levels as investors were understandably worried.
- Calls for earnings collapsed, and a deeper equity market correction were abundant.
- The UST 10y yield drop toward 3.30% seemed to all but confirm the
1H23 recession. Because, after all, the bond market is 'smarter' than
the equity market, right? Except when it isn't.
The Journey – Part 1: What we observed along the way
- The jobs market turned out to be stronger. Just see the data from a few weeks ago.
- Noticing the strength in jobs, the Fed changed its base case to a soft-landing.
The significance is that the Fed no longer feels a need to push back
against higher asset prices to accomplish its goal of containing
inflation. Supporting this change was:
- Powell doubling down on his 'disinflation' comment at a speech last week. No walking things back.
- Last week the Fed's Williams also acknowledged that 5% to 5.25% may
be appropriate. Previously he was thought to be closer to 5.5%
- A solid belief from the Fed that we will see falling inflation: 1)
goods deflation, 2) wages falling as layoffs in higher paying
tech/industrial sectors are shifting to lower paying service sectors.
- It is now possible for the Fed to see inflation fall without being
forced to drive the economy into a recession and bring the unemployment
rate higher… Thus making the Fed less worried about rising asset prices.
- Asset prices, credit and equities, took notice and valuations rose. This is bringing cash off the sidelines to chase returns.
- Earnings are falling as expected but investors are willing to look through this and keep valuations, or multiples elevated
The Journey – Part 2: What may happen in the months ahead
- The narrative in the market shifted from hard landing to soft landing. Maybe the next step is no landing at all.
- This will keep high levels of cash looking to buy dips and chase
returns. 'Risk-on' is a risk. Investors can't afford to miss a rally.
- The blame game. Inflation got the blame for keeping earnings elevated in 2022. As we started 2023 inflation got the blame for pushing earnings lower. But if growth does not slow as much as expected, will inflation get the blame for stabilizing earnings? Possibly. This suggests 'good' inflation that comes from better growth. IMPORTANT!
- Inflation is falling though, keep that in mind. This
is increasing real wages and consumer purchasing power. A net positive
for top line revenue growth.
- Pushing the bad news out to 2nd half from 1st half of 2023
- Recession has been pushed out becoming expected by consensus to come in 2H23 vs 1H23
- As this shift, or pushing out of bad news continues, markets may
perform well as 'risk' of a soft, or no landing scenario needs to be
- It all comes down to inflation, not just falling
but becoming anchored at acceptable levels near target. We see the big
risk to be that it becomes unanchored, which would make the Fed restart
the hiking cycle. But we are not there yet!
- In the meantime:
- Fed fund futures are not priced for this. Thus there is a risk that the market pricing believes the Fed and those rates rise.
- As those discount rates rise, it could weigh on valuations, push yields higher, spreads wider and equity prices lower.
- BUT FROM WHAT LEVEL? This is the key question. We may get a sell-off in 2H, but perhaps from more elevated levels.
- Conclusion: It's difficult to forecast the future, but for now, over the nearer term, the risk seems to be higher prices.
- Our asset allocation thus has a more 'risk-on' tilt. Something we
started building upon last December. We maintain this bias and are
looking to add on dips.